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The Mutual Fund Show: Benefits Of Staying Invested In Debt Funds For Long Term

Fixed deposits have remained a popular choice among investors but the recent PMC Bank crisis has made them look at other options.

‘Piggy banks’ sit in a plastic bag. (Photographer: Billy H.C. Kwok/Bloomberg)
‘Piggy banks’ sit in a plastic bag. (Photographer: Billy H.C. Kwok/Bloomberg)

Fixed deposits have remained a popular choice among investors who want to invest their savings in debt. But the recent crisis at Punjab and Maharashtra Cooperative Bank prompted investors to look at other options.

And that’s where debt mutual funds come in. These funds are capable of returning superior gains, albeit at a higher risk, provide investors tax benefits and the ease of liquidity, making them a good alternative, Sunil Jhaveri, founder and chairman at MSJ MisterBond Pvt. Ltd., said on BloombergQuint’s weekly series The Mutual Fund Show.

“Most investments, even in the debt space are only for three-five year, including fixed deposits. Little do investors realise that every time these investments mature, they are faced with what is known as reinvestment risk, which means rates at which you will get to reinvest on maturity may be lower than their earlier locked-in returns,” Jhaveri said.

While bank FD rates have fallen by more than half over the past 22 years, there are debt funds where investors can lock-in investments at a fixed rate for as long as 25 years and safeguard investments from this risk, he said.

Watch the full show here...

Here are the edited excerpts from the interview...

We’ve spoken about some of these concepts at various points in time, but it’s also good to revisit them. Now, your long-term scenario is for debt space. Why are you saying this? When you do this with your clients, what is it that you typically tell them?

Sure. You must understand what the investors need. They need the preservation of capital, meeting their long-term goals, and leaving behind a legacy. These are the three ways of looking at it. By leaving behind a legacy, they generally think only in terms of property and jewellery, but never in terms of financial assets which includes both debt and equity schemes. They talk about the preservation of capital, which has a little bit of a disconnect as far as I’m concerned. This is because there is a beneficiary who can take that journey forward even if the original owners of these assets are no longer there. So, why should they bother about the preservation of capital? Let that be enjoyed during their own lifetime.

Now, having said that, as we know that so far there have been hardly any schemes in the mutual fund space that was really long-term. So, any time an advisor advised an investor to invest in a short-term debt fund with a view that whenever the exit load is over, they would say, should I exit now? The investors also would ask this. Moreover, if the three-year long term capital gains tax is over, then they would consider if they should exit from and go into something else.

What they fail to realise is that there is huge reinvestment risk. When you’re looking at it in such a short-term. So, in the last 22 years, interest rates have softened by 50 percent. So, there is a reinvestment risk because we look at fixed deposits. Let’s take one example which is a classic example with the investors—they look at three-year or five-year fixed deposit for investment purpose, then reinvest after five years may be at a lower interest rate, because in the last 22 years, as I said, the statistics have shown it’s 50 percent. If currently, the fixed deposit rates are set at seven-and-a-half percent, at some point in time they were at 15 percent. If somebody would have locked in a 15 percent long term FD, they would be sitting pretty much doing nothing, they would have had to do nothing whatsoever.

Because usually those products are not available?

They weren’t available, but nobody thought of it in terms of really looking at the long-term. Now, there are schemes that are available for a 10-year plus horizon or a 25-year plus horizon in the mutual fund space also on the non-equity side. But they’re pure debt schemes that follow what’s called ‘constantly rolling down strategy’. So just to explain to the viewers as to what this strategy is: Today if I invest in a 25-year G-Sec paper, it’s an open-ended scheme. Next year somebody else will re-enter or do additional purchase in that scheme. The fund manager will buy a 24-year resident maturity paper. In the third year, he will buy a 23-year resident maturity paper until it rolls down to zero in terms of the maturity value. So that’s what we call ‘constantly rolling down’ and these are two or three schemes which are available in the mutual funds’ space, debt space and long-term space.

So, your basic hypothesis is that because there might be a case where rates which have come off over the last many years might stay on the lower course and with that assumption, it might be better to enter into a long-term debt product simply because you get a lock-in at the current rates. These rates could arguably be higher than what we might enjoy 10-15 years down the line.

Absolutely. So, it’s not a hypothesis. If you showcase the data, we have shown in terms of how the developing countries went into the developed zone and how the interest rates will soften. So, in 2000-2018 if you see, the interest rates have softened even in the Indian context by 29 percent, and almost 40 percent in 2019.

Germany, if you take that example, almost 103 percent drop in terms of the interest rate scenario, which has gone into a negative territory, as we know. So, now, if India is going to be the third biggest country in terms of the GDP growth numbers, they will definitely be in the developed country zone and that’s the journey which we are talking about. So if you capture the current deals, which according to most of the countries across the globe, we are still on the higher side.

So by your point that is, in all likelihood, a very high probability. But I’m saying that in order to explain why this need, there’s a hypothesis that yields and returns are likely on the fixed side. Fixed returns are, therefore, likely to head lower. Therefore, because the current rates are slightly higher than what they arguably will be, there is merit in locking onto those rates.

Absolutely. Now let me put it the other way around. Because this is a long-term debt product, there will be a lot of volatility. Let’s assume you’ve captured a yield of 7.5 percent, and it goes up to 8 percent. Naturally, your returns will be on the negative side. But you have to treat this as a fixed maturity plan. Hold it till its maturity which can be 10 years or 25 years and automatically that interest rate movements will get evened out. Alternately, when the interest rates really go through the roof at some point in time from now to the next 25 years or 10 years, one should capture that deal at that point in time and hold it till its maturity. You will get the capture deal that you had at the time of that investment.

So, is it that we should not get bothered by the price movements?

So, you treat it like an open-ended fixed maturity plan. Whenever you have invested whatever you will which you’ve captured, you hold it till its maturity of 10 years or 25 years you will get that yield which you have captured.

A lot of people might believe that even though I’m entering into the middle in the long term, I’m comfortable, maybe for drawing some bit of money or taking a break from my investment and disinvesting it again after making a fresh assessment. Are you saying that even that is detrimental?

It is detrimental. That’s what we’re calling about reinvestment risk. So let’s assume you invested in this product for five years and you exit it at the end of five years, at what yield will you capture it after five years, you are really not sure. It can be much lower than what we are at current levels or could be higher. So, if it is at a higher side, you have fresh money to invest and capture that higher yield. So that means basically you are averaging your investment. Your yields are much higher than the current investment which you have done so far.

It is a numerical example. I think you’re saying if there are investors A and B, and with a presumption of certain assumptions that you’ve done, reinvestment typically leads to lower returns?

So just to give you an example, let’s assume that somebody invests today Rs 1 crore at 7 percent and holds it for the next 25 years. His value at the end of 25 years will be Rs 5.43 crore at the current yields of 7 percent, Rs 5.43 crore compounded annually. As against that, if somebody wants to reinvest every three years and assuming further that interest rates soften over the next 25 years by 250 basis points, that portfolio is Rs 1.25 crore lower than that Rs 51.43 crore.

So essentially the falling rate scenario if indeed interest rates point-to-point go down to 150 basis points in which case the returns would be lower.

Yes, much lower.

I have one follow up question though, a lot of people would ask that what if, at the end of five years that yields are higher than what they are right now, due to whatever reason? Sure, then does the reinvestment actually yield better returns? The counter of that I have and I want to give you that, that if indeed that is the case, that wouldn’t the value of my investment be lower anyway?

At that point in time after the fifth year, maybe or maybe not because it depends on how much their interest rates have gone up or gone down, because you have an accrual of five years—which is already inbuilt in your cushion. Let’s assume the yields have gone down by a quarter of a basis point, I don’t know the exact calculations, it may not have any impact. Even if the yields have gone up, it may not have a substantial impact because you already have a cushion of 7 percent over the next five years. So, to answer your query if you will go negative, maybe not. I don’t know, it depends on how much interest rates have gone up. 25 basis points, 50 basis points, 100 basis points, etc.

So, what is the best way to make this long-term wealth creation? Since you’re saying that don’t just look at equities in the long term, look at debt also from the long term. Part one, is there some math which we can show as to what is it that people should ideally do? Part two, what are these products which might be available in the market currently?

So how do you position this long-term debt? So, there are various ways of positioning and one is as we just spoke: open-ended FMP. You invest and you forget about it and then you get your captured yields. At any time in future if the interest rates have softened from the current levels when you have invested in want to exit, you exit, you will get your accrual plus capital gains and you’ve made much better returns than what you would have thought of.

So that’s one way of looking at it. The second way of looking at it is why can we treat this as a passive debt allocation under the asset allocation strategy? Under asset allocation, you have debt and equity. Based on the market valuations, you are increasing or decreasing the equity valuation. Then why not make your passive debt portion without any credit calls?

Currently, the problem is the credit cause has created havoc in the market and that’s the reason why people are running helter-skelter. So, should we exit out of mutual fund debt schemes altogether? Now, these are the schemes which are only investing in triple-A-rated corporate bonds of G-secs. So the second part is- you treat it as asset allocation, part of the debt component as a passive investment and forget about it and whatever you need to do up and down in terms of the equity based on the valuations, you do that. So, that’s the second way of looking at it.

The third is, you want to leave behind a legacy. We treat property and jewellery multi-generation asset, but you never treat this as a multi-generation asset. So, you convert that into a multi-generation asset and let that be passed onto your beneficiaries. The other way of looking at it is deferred as a systematic withdrawal plan.

What is that?

So, SWP as a concept is very popular in the mutual fund industry. After having invested in a 10-year product or a 25-year product, you do not withdraw anything for the first five years or 10 years, let the money grow. Once you have an inbuilt cushion, then you start withdrawing what we call deferred annuities. After five years, you can start withdrawing 7 percent, 8 percent or after tenth year you want to start withdrawing then the cushion is built, and your withdrawals can be on a higher side also.

Can you give us some illustration?

So, if you start withdrawing from the sixth year onwards at 7 percent- which is at Rs 8,300 per month on a Rs 10-lakh investment.

Let’s just start from scratch.

So, you are investing let’s say Rs 10 lakh, this is done for a period of 25 years, Rs 10 lakh, and you don’t touch the money for the first five years and you start doing is SWP at 7 percent which is Rs 8,300 per month.

What do you mean at 7 percent? I mean, I withdraw 7 percent of the corpus?

Yes, of the corpus, which is which at that time so, it can be Rs 40 lakh corpus, okay because you let the investment be for the next five years and you’ve done nothing about it.

So, you’re not touching that corpus at all for the first five years? The amount then goes to what Rs 14 lakh?

Yes, Rs 14 lakh approximately at 7 percent and then and then you start withdrawing 7 percent on that Rs 14 lakh which is Rs 8,300 per month.

So, I would draw it on a per month basis?

That is your call, you want to do SWP on a monthly basis, quarterly basis, entirely the investor’s call. At the end of 20 years thereafter, you have withdrawn Rs 19 lakh- Rs 19.84 lakh to be precise, but the corpus at that point in time after 25 years or over is still Rs 12.28 lakh.

Now let’s take that example by deferring the annuity after the 10th year. So, you’ve not withdrawn anything for 10 years, you will be able to withdraw at 7 percent Rs 11,700 per month instead of Rs 8,300. You have withdrawn Rs 21 lakh and Rs 10,000 over the next balance period and the residual value of that after 25 years is still Rs 19.88 lakh.

Wow, that’s a substantial difference.

That’s because you’ve just deferred your withdrawals.

So, the amount that is left compounds at a higher rate and the residual value is much higher.

Absolutely, because you’re withdrawing 7 percent. You withdraw 8 percent, of course, the residual value will come down. If you withdraw at 9 percent at some point in time, you may start dipping into your principal also. So, one has to be careful as to how much can you withdraw even after deferring the withdrawals.

So, let’s assume, I need more money, I’m still dipping into my principal instead of Rs 10 lakh. I’m leaving Rs 9 lakh for my beneficiaries. How does it matter? Because the beneficiary has another 30 years to carry that investment forward. So, don’t think in terms of only self-preservation of wealth. Finally, if you need the cash flow, you need the cash flow.

So, you are saying that on the dead side, there are products available right now, which can give me a lock-in at the current rate for a period of 25 years?

25 years and 10 years.

What are these examples and how does one go about investing in them?

So, there is Nippon Nivesh Lakshya—which is a 25-year product where they invest in G-Sec of 25 years when they started. They invested in a 27-year G-Sec paper. It delivered the best returns in the current market context because they captured the yield of 8.20 in 2018. Currently, that yield is about 7.10. So, you can imagine the accrual also. At the same time, capital gains also- that’s a 25-year product.

Then there is Axis Dynamic Bond Fund, which invests in triple-A corporate papers only, which is a 10-year product again. So, again something similar anywhere between 760 to 770 is the gross yield which they have captured, you invest in that hold it for 10 years, you will get that gross yield minus the expense ratio.

Then, there is a recently concluded Bharat Bond ETF by Edelweiss. So, they have collected a huge sum of money. Again, a similar concept and a PSU triple-A papers only. So, there is no credit cause as you can see from any of these investments. So, you hold it for the next 10 years and naturally you will get the returns that you are looking for at the current yields. On top of that, as I said, as in when you want to exit with the interest rates go down because the RBI has come up with a lot of these twists as well as LTRO, etc., which has softened the interest rates further.

So, going forward if the interest rates continue to get to remain benign or on the softer side, after two years, three years, four years, five years, your investments currently in these products can fetch you capital gains also.

There is another product which is ICICI’s Prudential All Seasons Bond Fund. They follow a current account deficit index, it’s an in-house index. Based on that, they increase or decrease the duration from one year to 10 years. I would position that particular product also has a long-term solution on the debt side. So, there are four or five schemes which are available in the market.

And would you presume that these investments would obviously get the benefits of indexation as well?

Yes, because these are all mutual fund products. After three years, the long-term capital gains tax will be at 20 percent with the indexation benefit.

Just wondering, the track record of any of these or all of these. Bharat Bond is a recent one, but the others they have actually, there is no question mark. I mean, the houses are all spic and span. So obviously there is nothing but is there any concern that people should keep in mind when they’re doing these investments?

Only the interest rate fluctuation, because you can’t go wrong on the credit side. The only way in which you can actually have some kind of fluctuation in your returns or your investment- the values of investment is basically the interest rate fluctuations.

So, if somebody invests currently at 750, and the interest rates go up to 8 percent in a short term period, when we are talking about equity, how volatility gets reduced when you go for longer periods; five years, 10 years, 15 years. volatility goes away. Similarly, if you are holding it for longer periods, even in the debt side, the interest rate fluctuations tend to even out and that’s exactly why we are saying, think debt, think long-term.

A lot of people have spoken about how the credit policies brought about some change in the yields etc. Therefore, whether that opens up or strengthens investment into certain kinds of non-equity mutual fund categories. Any thoughts on the same? For example. the LTRO that has been announced, the resulting fall in the yields that have happened and maybe the rise in the NAVs. Is there any way to distill this to an investment within the debt space?

The story is already finished, right? They said they will continue for some time hopefully, because of that one lakh crore of LTRO is basically saying that RBI is going to lend to these banks against their own securities for one to three years instead of overnight, at the same rate as overnight- which is 5.15 percent repo rate. So that’s why, they are trying to push the banks to borrow at 5.15 and lend it into the market, which was not happening currently. So that liquidity infusion will definitely soften the yields, and that has softened the yields on that one to three-year segment. That’s why the short-term plans- what we were talking about, with one to two, two to three years in your average maturity are the ones that have benefited the most.

But again, I’m saying that you know, don’t look at this debt component on a short-term horizon now, start thinking long-term. Because our mindset so far in the mutual fund industry, the way we been told to look at debt also is very short-term, one-year, two-year, three-year, then park your money here, right? Why can I park my money for 10 years? Is your PPF money not long term enough, which is also debt, right? You’ve never looked at that portfolio ever. On top of that, you don’t have liquidity in your hands. But here with these kinds of products available in the market, you have liquidity you have yields, you can manage various needs of the investors. It’s a need and a solution approach. So how do you approach that? Whatever the investor’s needs are is entirely the investor and the advisers’ choice?