With the U.S. 10-year treasury yield surpassing 3 percent and the Indian bond yields hardening, is it an opportune time to diversify into debt and money market funds?
While the market focuses a lot on the 10-year curve, what is more interesting is the front end of the bond market where 1-4 year rates are extremely attractive compared with the repo rate, Suyash Choudhary, head of fixed income at IDFC Asset Management Company, said on BloombergQuint’s weekly series The Mutual Fund Show. He expects a 75-100-basis point increase in these rates over the next year or so.
He also suggested investing in AAA-oriented short-duration funds.
Nikhil Kothari, director, Ética Wealth Advisors, agreed as he expects the RBI to maintain a status quo on policy rates for the next year.
Here are edited excerpts from the conversation:
Everybody talks about how bond yields have gone up, but this may not be the end of it all because of what the U.S. Federal Reserve could do and possibly what the RBI could do. What is your sense?
A lot of time is spent on what the 10-year bond curve is doing. What is much more relevant and interesting is what the front-end of the bond curve is doing. If you see where 1-4-year rates are, both on the sovereign and corporate bond curve, those are extremely attractive versus where the repo rate today is.
For example, repo rate is at 6 percent and a 2-year corporate bond is almost at 8 percent. So, how much are we already discounting? If you were to buy now and carry up close to 8 versus a repo rate of 6, what is already embedded in the price.
Our sense is, probably, 75-100 basis point of rate hike over the course of the year is already priced in as far as front-end rates are concerned. So, there is incrementally some pressure on macro and globally things have become more challenging. But on the other side, you are also getting rates which have started off pricing in probably 75-100 basis point over the course of a year.
Would it be important for investors to log in or invest into debt funds? They are not the ones who give attractive returns. So, why should investors think of parking money in debt funds?
Simply because of Rs 100 of our savings, you don’t want entire Rs 100 in the pursuit of wealth creation like equities or real estate, as those asset classes are also subject to negative volatility.
So, I would imagine, given the size of our fixed deposit market, that bulk of the savings of an average investor will actually go into fixed return products. So, bulk of it chase income rather than wealth. So, if that is the criteria, you actually have to say what is the core portion that chase income and how much of that core portion should go into fixed income mutual fund.
If then the argument shifts to whether it is fixed income mutual fund or fixed deposit, I would argue that fixed income mutual fund wins, given the higher liquidity diversification and so forth. So, it is not a question to imagine whether you should diversify equity to fixed income but rather what portion of the pursuit of fixed return money should be dedicated to fixed income mutual funds.
Do you have an internal formula of what you do or what investors do personally out of this portfolio which is chasing not wealth but income? What proportion should be in what kind of fixed income asset class?
Our thesis is very simple. India is a country where the risk-free rate is almost at 7 percent. So, unlike the parts of the western world, in India you didn’t complicate fixed income to much. The context is that, if you see most of the investors in fixed incomes, they have recently converted from fixed deposits.
So, the mindset is very conservative. They would typically dislike volatility and they will dislike extreme forms of risk even in fixed incomes. If you apply this to fixed income mutual funds, you have to control for both duration and credit risk for the bulk of your portfolio.
The interesting thing is, in context of last 2 years, in India people intuitively know how to control duration risk. So, they know this is not the time to buy the long-duration debt funds as NAVs have been volatile. But it is less intuitive to control for credit risk because credit risk does not manifest as day-to-day NAV volatility.
But if you are trying to be conservative in fixed income, you should control for both credit duration and credit risk. Simply put this, throw up a basket of ultra-short/short-medium-term kind of products which are largely AAA-oriented.
What kind of funds will you recommend?
As a generic aggregate, I would imagine around 75 percent of your portfolio should be in conservative fixed income, given that fixed income is not everything that you are doing. So, fixed income is for the pursuit of income. So, 75 percent of fixed income should be in AAA-oriented ultra-short, short-medium funds. So, how will you determine it? Unfortunately, the answer is not that simple.
You or the fund adviser has to be able to see fund fact sheets and fund mandates to determine whether predominantly a fund is AAA-oriented or not. So, you don’t want to get into individual company-level credit analysis but to whatever extent the security mirrors the actual rating profile, you should be looking at funds which are 80-85 percent AAA for the bulk of your portfolio, which is around 75 percent.
Is this information publicly available?
It is through public disclosures of mutual funds, but you have to get into scheme-level dynamics. You can’t do it at aggregate mutual fund-level or even at category-level. Probably, not at a category-level too because credit risk is not controlled at category-level, barring 1-2 categories. For the balance 25 percent, you can pursue alpha strategies, which means you can take on risk which can manifest both ways.
So, if they are positively correlated to returns you will make more than what you make in 75 percent of your basket. If they tend to get negatively correlated for a 1-2 year then you will delete from returns that you make from 75 percent of your basket. In this 25 percent, we speak of funds which take higher or more dynamic duration risk where you could slot your dynamic bond funds, gilt funds or income funds or funds that take higher credit risk where you can put in credit opportunities or credit risk funds in the new classification.
So, this 25 percent will be for pursuit of alpha and the 75 percent will be conservative. Unfortunately, the way this is getting perceived by a part of the market is people think that duration is the only risk which needs controlling. So, a lot of credit risk is put in as part of the 75 percent bucket which, in our very strong view, should not be the case.
When you are saying duration versus credit risk, would you care to just dump it down?
In fixed income, there are two types of risks you take in order to generate excess return. One is interest rate risk, whereas the fund manager tries to increase or reduce duration alongside or in view of the market dynamic or what they think about the market. The other is through credit risk where they take on a higher credit risk which increases the portfolio running yield and therefore they try to deliver high return. So, both these are legitimate risks.
It is just that the manifestation of interest rate risk is through daily NAV volatility. Suppose, interest rates go from 9 percent to 7 percent — the positive aspect of it. But what has happened over the last one year, interest rate has gone from 6.5 percent to 7 percent. So, the interest rate volatility will work against you.
So, duration-related funds will pose negative returns for you and then you tend to get scared of those funds. However, credit risk funds will not typically manifest day-to-day NAV volatility because credit risk is more of a binary risk. It will strike you if it has to strike you one day, and, on that day, it will erode a portion of your portfolio.
But that doesn’t mean it is not a risk just because it is not showing day-to-day volatility. So, 75 percent of portfolio — low-credit or low-duration risk or low interest rate risk and 25 percent — more active interest rate risk and some bit of credit risk.
Watch the full interview here.