The Mutual Fund Show: Is This The Time To Consider Dynamic Bond Funds?

GEORGE HEBER JOSEPH: Absolutely. It is a very complex subject, you need long standing experience to understand what happens to the interest rate scenario as well as the inflation moving up scenario, which is the current scenario which we're painting, and also to make money in the whole scheme of things. It becomes a very complex subject for a layman. That's why if you look at the current structure of the interest rate movements what we are seeing and what we believe in, is that there is a clear possibility of the inflation moving up—the global inflation moving up and also the Indian inflation moving up. There is a clear chance of interest rates moving up because the inflation is a very clear determinant for the interest rates also. We are clearly posing for a situation that maybe in a three to five years’ time, the interest rates will be significantly higher than what it is today.

GEORGE HEBER JOSEPH: Absolutely. When we look at the recent past and what has happened in the industry, as well as in the mutual fund industry also is, there's a lot of pessimism around the debt products mainly because of the fact that people started believing that equity is less risky than debt but it is not the case. We have a strong belief that on a risk-adjusted basis, debt stands out even today compared to equity. If you want to have long-term returns, which is relatively safer, and also builds a clear wealth bucket or an asset allocation mix that you need to have, I believe that there is then a requirement for a debt product in your portfolio. If you look at the problem which an investor faces, they don't know which part of the interest rate cycle we are in. Secondly, people don't know which product to choose from because the category of products in the debt side is quite enormous. There are 45 mutual funds and so, the things become very complex, you don't know which product to choose and what kind of risk each product is carrying. When you say dynamic bond fund, that doesn't mean that all of the dynamic bond funds are running in a similar fashion as each one has its own philosophy of running it. That's where the complexity comes but we believe that we are looking at it as a solution rather than a product and that is where we think that we are making a clear differentiation.

GEORGE HEBER JOSEPH: If you look at some of the funds, there are certain credit papers being bought into the dynamic bond fund also or say for example, inferior quality bonds are also taken and that's where a lot of chaos has happened in the industry. Also, there are bond papers which are very illiquid as well, even if it might be of reasonable quality, but it is illiquid in the market especially when it comes to corporate bonds and different products are run in different fashions as I mentioned earlier. So, that is why you need to have a USP which creates liquidity very reasonably well in the product. Secondly, you need to have high quality bonds in the basket and also you need relative safety, so that’s what an investor is looking at. After talking to various mutual fund distributors and various wealth outlets, what I could clearly gather is that this is the pain area for investors that they don't know which product to choose from and there is a varied variety of funds in the market within the dynamic bond funds. So that's where we saw an opportunity to place it very uniquely and very interestingly, to make it so liquid, and also have a majority basket of the bonds as government bonds.

GEORGE HEBER JOSEPH: If you look at it, what is a dynamic bond fund? The papers which are you going to buy in the bond fund has to move from different maturity buckets from a low duration bucket to a high duration bucket according to the interest rate scenario as well as the conditions of the market. Now, that has to be easily done because when you have very illiquid papers in the portfolio, what happens is that even if you spot the opportunity, you are not able to move from one maturity bucket to another maturity bucket. That is a typical problem that fund managers face. That’s why we thought that here what we are looking at in a bond fund is that, we want the quality of the papers to be of utmost importance which itself means the relative safety and relative liquidity is very much a given and the investor doesn't need to worry about—if I pull out money tomorrow, whether I will get my money back or not. Ultimately, a bond is nothing but giving a loan to a company. That's the way I simply put it whereas in equity, you are owning shares. Here, liquidity is of paramount importance. So we have a simple investment philosophy which we have put in place at ITI Mutual Fund, as ‘SQL’, S for margin of safety, Q for quality of the business and L for liquidity. All these three things have to coexist in the product, so that the product becomes very successful from the investor perspective.

GEORGE HEBER JOSEPH: That's right because the typical thing what we have seen is, if the fund manager has a long-standing experience, in our case, Mr. Vikrant Mehta has 25 years of experience in managing funds, and he is our Head of Fixed Income — he clearly believes that a portfolio has to be highly liquid, and for that we are having 60-80% in government bonds and it typically means that you look at various maturity profiles and see where the opportunity lies and move than money very dynamically. Now, as you have seen in equity markets that same thing applies in the debt market also, that risk on and risk off keeps happening, and you have to spot the opportunity in which maturity bucket the opportunity lies. Today, for example, the 10-year G-Sec almost 80% of the bonds are with RBI. If you look at the opportunity laying elsewhere between three years to a 10-year bucket or even beyond a 10-year bucket, there is an opportunity which we clearly see. So, if you want to place the opportunity in a timely fashion and take it out also liquidity is of paramount importance and that’s what a dynamic bond fund has to clearly focus on. That is what we believe, we'll be definitely doing it without taking any interior. We are not going to play credit, we are not going to play in with any fancy papers. We are going to play the interest rate cycle very clearly through the government bond basket and play through the entire interest rate cycle very seamlessly. You need experience, you need to have the product knowledge as well as have a process to run this model very nicely so as to achieve superior, risk-adjusted returns related to the industry.

GEORGE HEBER JOSEPH: Coming to a point that typically an investor doesn't know where to place the bets and secondly the typical problem that investors face is, which product to choose from and what are the risk levels involved in these products. So, all three are a complex subject. What we want to make is that, make it a very simple solution. My experience is, even previously at ICICI Prudential also, that if you identify the need of an investor and create a product around it — which was balance advantage funds for example the product designing and the entire modelling was done by me, and eventually that became a very successful product in the market and became a category by itself. Today, policies and bond funds are there, they're run by different industry participants but if you create a very niche positioning for the product which meets the need of the investor, then that product can be a very scalable opportunity and also at this juncture of the interest rate cycle where the interest rates moves can move here and there depending upon the risk on-risk off scenarios happening globally, as well as the bond buying slowly coming out from the RBI side, it needs an expert hand to maneuver this entire scenario. That's where we believe that dynamic bond fund provides a very fantastic opportunity to move between maturity buckets and capture the opportunities which is coming up in different baskets, which is what we’d like to do. In my view as to answer your question in a nutshell, it is one of the best products in the entire debt category, that is what we believe in and this will be our flagship fund for ITI Mutual Fund.

RAGHVENDRA NATH: So, this category has been there for many years. I think the first dynamic bond fund was launched sometime 14-15 years back and if I remember when I was in Birla, I was the one who had launched that first fund, Birla Dynamic Bond Fund and it was way back in 2003 or 2005. So, the category has obviously evolved and the category has done well sporadically, whenever the interest rate cycle has been positive.

RAGHVENDRA NATH: No, when the rates are moving down. In that scenario, most of these long dated bonds basically give good price appreciation and because the dynamic bond fund has primarily government securities, they are able to adjust the maturities fast and quickly, than let's say in a corporate bond fund—where most of the papers will be held to maturity and because government securities are far more tradeable and liquid and therefore you can straddle across the yield curve based on your comfort rating. From that perspective, dynamic bond funds are indeed dynamic and I've seen dynamic bond funds going down to as low as one-and-a-half, two years, and going up on the maturity curve or let's say more duration curve of 8 to 10 years also, and from that perspective, they are very dynamic. The issue is, first of all, it's meant for sophisticated investors because investors who do not understand price risks may get shocks while investing. When you are investing in a fixed income mutual fund product, your expectation is that it's going to beat inflation by 1-2%, or it will at least keep pace with inflation whereas dynamic bond funds—if you were to just look at the 10-year track record, every fund house would have delivered a 2-3% return in bad years and 14-15% returns in good years—which basically means that the volatility of return is far higher for the comfort of an average investor who doesn't have the sophistication to understand the volatility of the bond markets. That is point number one. Point number two is that, ultimately what a fund manager is doing in dynamic bond fund is estimating where will interest rates be after six months, eight months, nine months, that's what they're doing and it's a very closed market. There are maybe 200-300 participants in that entire market, the entire government bond, government securities market and everybody is sophisticated and thinking alike. When everybody has the same view, many times that view may not come right and therefore, it will be like what happens in a stock market. Everybody thinks that the stock market will go up and it surprises on the other side. So, those kinds of surprises will always be part of any trading portfolio. So out of 10 bets that a fund manager will take, maybe eight will go right and two may go wrong. So that's the other thing that people need to keep in mind that dynamic bond fund by nature while it's investing in long dated securities, is taking a short call on the interest rates. That's my point that that while we have also as wealth managers recommended dynamic bond funds at a certain point in time but today when we are sitting at the bottom of the interest rate cycle, I really don't find why somebody should invest in the fund because the only way that interest rates are going to go, is up. So, the amount of returns that you can get from a dynamic bond fund will be limited than what you will get from let's say from a corporate bond fund which may have a same duration, but a higher yield to maturity.

RAGHVENDRA NATH: I really doubt as interest rate cycles in India have been 18 to 24 months kind of cycles and we've seen interest rates go down sharply and also go up very sharply because Indian inflation is very transient. It is a high inflationary country yet, at moments we have low inflation and then interest rate inflation jumps up and the RBI has no choice but to increase interest rates.

RAGHVENDRA NATH: Yes, not right now but the category is a fantastic category it has generated fantastic returns in appropriate times.

RAGHVENDRA NATH: It's again a very contrary view of what people are saying in the marketplace. I love the credit risk category right now. The credit risk category in its current avatar—the credit risk category has gone through a lot of storm in the last two-three years but if you look at some of the funds and I don't want to name every fund here but there are funds, out of maybe 20-25 credit risk funds, at least 8 to 10 out of them have a very clean portfolio right now. The difference is that, today we are sitting in a very unique situation while the AAA rates have come down sharply, the AA and single A rates are still elevated. The spread between AA and AAA is almost 250 basis points today, which is a historic high, it always used to be 60-70 basis points. So just imagine, a AAA rated corporate bond, the yield to maturity is around 5.5%, and a portfolio which has 50-60% AA, the yield to maturity is 7.5%. So at 200 basis points you are getting for just marginally lowering your credit risk. So, if you move from AAA to AA, you're basically getting almost like a 200 basis points kick up and most of these funds today have much better quality portfolios. Even the single A exposures are very good names, and the average majority of these portfolios are much lower than a typical banking and PSU or a corporate bond fund portfolio. So, there’ll be low volatility if interest rates were to go up. The sensitivity to interest rates for an AA or single A is far lower, and then by having lower maturity, the sensitivity reduces even further. So, you have a good credit play where you can earn 6-6.5% post tax in these funds.

RAGHVENDRA NATH: I'll disagree to it. In fact, you just go back to 2018-2019 and look at the returns of credit risk funds. The biggest storm that the industry faced was defaults and even in that year the returns were positive, and returns were 7-8%. Now, returns could have been 10-11% because interest rates were coming down in that year, but the other thing is that as a category, you did not lose money in that and globally high yield—which is credit risk in India, globally, it's called high yield—is one of the most attractive categories for most retail investors. In India, somehow, because of that credit storm, which basically we faced in 2018-2019 and 2019-2020, the category has got a bad name.

RAGHVENDRA NATH: Yes, because you don't have any risk on capital. If you diversify across mutual funds, each fund is diversified across 40-50 names, where is the risk of capital and a fixed income investor is worried about risk of capital, that he should not lose his capital.

RAGHVENDRA NATH: You can look at this the ICICI Credit Risk Fund, SBI Credit Risk Fund, IDFC Credit Risk Fund, HDFC Credit Risk Fund—all these portfolios are absolutely clean for use and as we speak. Obviously, things may change but as we speak the portfolios are absolutely clean.

RAGHVENDRA NATH: I think all of us are in sync that markets have run up quite a bit and everybody basically has a doubt in the mind whether this rally is sustainable or not. Most fund managers are saying yes, it is, even economic fundamentals when you look at it—yes, it looks like the rally can sustain itself. What kind of returns you are going to get in the next one or two-three years is basically obviously, nobody knows, only time will tell but at the same time in the last one, one-and-a-half years there's been an unprecedented rise in certain stock prices and valuations are stressed in quite a few sectors and stocks. When I look at markets at historic highs and as you said in the beginning of the show risk return is not very favourable as such today as we speak than what it was maybe six months back or one year back. I would like to then play safe, at least for some portion of the portfolio. So, my suggestion will be to look at fund portfolios which are more value-oriented, which have more old economy stocks and where the valuations are more reasonable because the thing is that if this rally has to sustain itself, and go further from here, basically the rally has to become more broad-based. So, sectors which have not partaken in the rally till now, those people will start going after them because there the valuations are far more reasonable. PSU banks is one such category. Suddenly, all these banks are giving some exceptional profits and suddenly there is a kind of wind blowing in their direction whether it is for two years, three years, four years, you don't know but the kind of valuations that they are sitting on are ridiculous in terms of where the private sectors are. So, almost maybe 1/4 of the valuation of a typical private sector bank. The thing is that and there are so many such sectors basically, such as engineering, capital goods, power sector, metals—there's been a rally in metals but still the prices are nowhere basically commensurating with the kind of profitability that these guys are going to churn if the metals’ prices are to sustain itself. So, I like one such fund in the large-cap category which is Nippon India Large-Cap Fund. The fund has been around for many years I think maybe 20 years or so and the fund has also underperformed for some period of time when there was a one-sided rally going in the new economy and all that. But right now, as we speak that fund has almost 50-60% exposure into stocks where the valuations are very reasonable. Therefore, I see that in the next one or two years this fund could at least deliver above average returns. I don't know whether it will be at the top of the category but it definitely will deliver above average returns.