The Mutual Fund Show: How To Look At Investing In Debt Schemes

VISHAL KAPOOR: Firstly, thanks for recognising debt as a very large and very important asset class today we know equity tends to almost have the limelight because it seems to be a lot more action oriented etc. We have to keep in mind that the bulk of investor savings, even today, is in some form of debt, and therefore the impact that understanding debt can have, is far larger a way that impacts your financial outcomes. It’s very important to understand debt, is the first point I’d like to make. Having said that, it can be a complex topic, which is why at IDFC, we’ve tried to simplify it as much as possible and really provide an approach to how you can build a debt portfolio. The reason I’m saying that is because behaviourally what we think we say and a lot of our partners give us feedback is that, 90% of the time that we discuss is about which equity; either stock or fund or what part of the market and debt is almost like the remaining portion which is okay now what do I do with this lump sum which you just put into either a deposit or some form of debt fund and what’s the correct strategy for now. We do think it’s very important therefore to look at debt as any other asset and therefore have an allocation. That’s what we think is a better way to approach it.

VISHAL KAPOOR: That’s right. One simple way to look at the allocation across debt would be, go back to your needs and see what’s the spread of the risk or the type of objectives you have for your debt allocation.

Now we think that the simple way to do it without over-complicating it is: to divide your debt allocation into three buckets. We call it the three-lens framework. The first lens, the first bucket should be around your liquidity needs. This is important for every investor to have a proper amount set aside which is easily accessible, is not exposed to a lot of risk and which is typically for your emergency needs or for just passing by or keeping some extra cash surplus etc. It is nearly a replacement for a savings account in some sense. That’s where your overnight funds and cash funds coming in, so very low risk, very high liquidity, it is just a parking spot. The second bucket, which should be the core or the largest part of your debt portfolio, which is what we call the core bucket, is an area that we think, you should not be taking a lot of risk. So, this is an area, keep in mind the purpose for debt for most customers is safety and it is to try and earn reasonable returns without taking too much risk. So, if that’s the objective, it’s very important to be able to go towards the highest quality of assets available, therefore don’t take credit risk in that bucket and keep the duration short to medium in line with your objective. If your objective is to keep money for six months, then that’s the type of product without taking too much credit risk that you should go for. If your objective is maybe slightly longer maybe two to three years, then you can choose that duration of products but the underlying principle should be that you match duration with your investment horizon and you keep credit risk the lowest possible. That’s where we offer a whole bunch of our products, which are absolutely the top quality in terms of either being AAA oriented or higher or sovereign, essentially. So, we don’t take credit risk in this core bucket of products, irrespective of the duration. The third bucket which is what we call the satellite bucket is where you can now introduce a bit more risk. So, this is an area where you say that okay for some part of my debt allocation, I can afford to take risks because I may have a longer holding period or I want to play the cycle. So, the two risks that you can take there is one, you can take higher credit risks, if you believe that the spreads available are more attractive today or you can take a lot more duration risks if you think that the cycle will be in your favour or the risk adjusted or duration adjusted rate available is very attractive. So that’s the place for you to take risk. I think often we get confused between these buckets when we don’t think about it this way. So if we take the credit risk and we place it as the largest or the core part of our holding, then there’s a bit of a mismatch in our minds. That’s something that most investors should try and avoid.

VISHAL KAPOOR: That’s right and again, it’s all about what you expect, what’s your risk appetite, how sophisticated you are etc. This is a framework which for most normal investors, should work because like I said most normal investors are not really chasing the extra 10-15 or 20 basis points, they really want principal security first.

VISHAL KAPOOR: I don’t think it’s bad to not take any risks in debt in a sense that if it’s a certain allocation, then it can offer you reasonably attractive returns. We have to keep in mind that in different parts of the cycle debt can actually outperform equity as well, it just depends on what part of the market or cycle you’re looking at. So, it’s just being conscious about what your allocation is. So, when we look at equity, a lot of advisors, a lot of people will say that don’t over allocate into a thematic or a high-risk strategy. It’s similar here but then that doesn’t mean that good risk adjusted returns cannot be had provided go about it very methodically. Why are you chasing it, how much risk can you bear and if there are some shocks—because keep in mind some of these shocks tend to be volatile which is intermittent and over a longer period of time, they may actually balance out. So, if your holding period is adequate because you did not need the liquidity and it was a smaller allocation, it can actually pay you quite handsomely too.

VISHAL KAPOOR: That’s right. So, for our fund house for example, this will be available to all our partners as well as investors. If you look at our products, we’ll have a label whether it’s a support bucket product or it is a satellite bucket product or it’s a liquidity bucket product. So, it makes it easier for you to decide. Hence, you don’t necessarily have to get too confused about the name and duration and looking under the hood in a very detailed way. You can just look at the label and try and figure out that this is generally going to have this strategy. It’s also important to stick to that. Even when, it does look like it gets very lucrative to change one part of the market, it is very important then to stick to that principle.

VISHAL KAPOOR: Firstly, the target maturity fund, as the name suggests, it has a target maturity which means that it will come to an end on a certain date unlike an open-ended mutual fund which is indefinite. So, like in our case, we have two funds, one ends in 2027, one ends in 2028. So, it’s a six years and seven years to maturity. In some sense you can think about it like a quasi-bond which matures on a certain date and gives you back the NAV on that date. It’s not principal, this is obviously accumulated benefits as well, that’s one. The second in our product what we’ve done is that we are going to invest according to the Crisil gilt 2027 and 2028 index, it means that the investment will only be in gilt, by definition means that it’s the highest quality of debt available. So, we’re not taking any credit risk of any kind in this fund. It’s a very simple one, it’s almost like buying a portfolio of gilts and holding it to maturity in 2027, or 2028 depending on the six year or seven-year product that you choose. Now, what’s the benefit to you as an investor out of that? The first is, like the quotation on a gilt, the index also today will give you an implied yield, the index does have a yield so you have some better visibility on what your likely returns could be if you held onto maturity. For example, if the first of these funds has let’s say a yield or the index has a yield of 630. Then if you hold on, the fund manager will get 630 if you hold onto the end, less expenses.

Right, so that could be the type of return in a ballpark sense that you could expect. There are some leakages in terms of replicating the index or reinvestment risk, etc. but this is some variation you will have but it’s a far better visibility than many other funds and I think the investors would have seen that variability in returns can be quite high across many categories of debt funds also. This reduces that variability, if you hold on to maturity. Just moving on to some of the other benefits of a mutual fund, like any other bond or unlike many bonds where you might struggle with how do I come in, how do I get out, etc., end of the day this is still an index fund and like any other index fund you can come in and go out whenever you want. So, while of course the benefit would accrue to you through the yield-to-maturity or through the visibility that we’re talking about, if you hold to maturity, nothing stops you from coming in or going out in between because it employs the very convenient platform of a mutual fund or an index fund. Because it’s an index fund, it’s a relative passive strategy, it’s also very low cost. So if you look at this and compare this to the actively managed products or the more complex products in a sense, it’s a very cheap or a very cost effective way of holding to a high quality basket of government securities; G-sec and T-bills, holding it over a period of time, having reasonable visibility on the returns, which is excluding the costs, and therefore having a lesser amount of, in one sense, volatility around how things are working or not working.

VISHAL KAPOOR: In fact, to be honest, we’re launching this product now because we feel there’s a specific opportunity right now, which makes this type of a product very attractive or relatively attractive. The opportunity is that, and I’m sorry I’m going to get a bit more technical, but to be honest here, the yield curve today, which is just how interest rates are spread out across different tenors, is extremely steep. If you look at the very near-end rates, overnight or one year or two years, these are very low on a relative basis. They’ve fallen a lot over the last couple of years but as you go into the 6-7 or 8 year maturities or into that sort of a tenor, they have not fallen as much, therefore they are well anchored even today.

So, if you look at for example how rates have moved over the last couple of years, the 6, 7, 8-9year bucket has not moved down as much. The one year or less bucket has moved on quite a bit, so it’s very steep. What you’re effectively doing right now is benefiting from that steepness. What that steepness also implies is, that this part of the market which is the 6, 7-8 years because it has not moved down, one may argue that even when potential rate hardening happens, the reverse happens which is the short end or the one year or two years or three years may move up a lot more, than what never fell as much. So, it’s a reversal of that rate which means that in some argument, the rate risk or the reversal risk over here is maybe lesser than at the shorter end. The second is that you’re also looking at your opportunity cost and what’s the alternative, and how does this compare to the alternative. So, let’s look at it like this. A lot of people would today, who want to invest4, 5 or 6-7 years will choose let’s say a fixed deposit. Now if you compare this to a bank fixed deposit, these are typically offering you between five to five-and-a-half percent. Keep in mind, the interest is fully taxable there. Here, you may have a higher yield, like I mentioned the current index yield is in the 630- 640 region, you do get the benefit of indexation on funds, so post indexation, assuming inflation being 3-4 or 5%, you take your pick. The net post tax return to this could be significantly higher, that is the other way to look at it. The third is that the alternative, like you mentioned could be that I keep my debt investments in the short end and I wait for some rate hardening and then I switch to medium to long end. When you do the math around the differential, in our belief, that rate high for some amount of pricing is already built into the current yield. So, keep in mind that the short-term rates are really 3 to 4%. So, even if they go up by 100 basis points, if you do a simulation and which I’m sure sophisticated investors will do and a lot of our partners will help customers with, the net return from this even after taking any mark-to-market adjustment, may still be more attractive.

So, we think that the yield curve today offers a very attractive position for six- and seven-year gilts and that’s the major reason to structure this type of a very innovative product. This is the first gilt index fund and it’s offered to the market in an index fund platform which makes it convenient. One quick initial point that I just want to highlight which is unique to target maturity plans which is that we will keep in mind that because it is target maturity, the maturity or the tenor of this product keeps coming down over the next few years. So in that sense, what it is called is a roll down maturity. So, if you are holding it for two years, the residual maturity, which also represents the risk on the product, the duration risk on the product is now no longer six years, it is four years, if you originally bought the six-year product. So as you keep holding onto it for longer and longer, the duration risk, the sensitivity to interest rate moves is actually coming down in this product. That’s the other benefit that investors can use in a product like this. Like I said it has many things packed in although it’s very simple to invest into it because it’s an index fund, a lot of it’s uniqueness makes it very interesting for a specific market opportunity today.

VISHAL KAPOOR: Absolutely. So even if you hold on for three years, the point is that, you bought a six-year gilt index fund, you held it for three years, if you invest before March of course you may have an additional indexation, a year that you can avail of and at the end, depending on where the price is and the yield is, whether it has moved up or down at that point in time, the entire point is the resident maturity at that point is only three. The balance three, it’s not full six. So, any mark-to-market risk at that level, is not as high as it might be today. Therefore, it’s always coming down.

HARSHAD CHETANWALA: I will try to put forward the views as you said, in the unbiased manner, which helps the audience to understand not just this particular fund but there are a few important points which I think Vishal did cover in his conversation. I think, one of the things which I really liked was the bucketing strategy which he explained and I think it’s not just the bucketing strategy for debt investments that strategy, actually we also use it for a lot of our retired investors. So, a very interesting point on that. I’ll quickly try to put forward my views on the NFO, one and of course, on the target maturity fund. So right now, the view is that at present, the interest rates are low and the interest rates are expected to increase over a period of time which I think you also covered in your talk with Vishal. That is where one thought in our mind is that it doesn’t make sense right now to go and block the money on a long-term debt instrument which has a long-term maturity. So right now, what we are trying to put forward to investors, is it is better to be in short duration, ultra-short duration or maximum, a bit of medium duration where the maturity is between around one-and-a-half to two years.

HARSHAD CHETANWALA: In a very simple manner, right now the interest rates are low. If in case I invest into long-term instruments right now, in a way, the interest rates are locked for these instruments. Tomorrow, down the line if the interest rate goes up; mind you, the interest rates or the price of the bond are inversely related. So as the interest rate goes up, the price of the bond which I’m holding right now which I’ve already invested into the price will go down and when the price goes down it has a direct impact on my NAV because the value of my portfolio goes down. So, from that perspective, we are trying to put forward that it is better to be in ultra-short or in medium duration debt investments.

HARSHAD CHETANWALA: So, what happens is that, let’s say that you’re entering into the product. Let’s take a classic example of the product which I think Vishal touched base on. Let’s try to club both these in a way because they are linked. So, when we are talking about a 6.5% or a 6.3% kind of return from this product before tax, this is based on the current interest rate of the products or the avenues when the investments are going to happen. Let’s say down the line, the interest rate goes up and the new papers that are going to come, the new bonds that are going to come, are going to offer a higher rate of return. So, what is going to happen is, let’s say that they start offering 7% return for example, so the 6.3% return—let’s say, the paper cost or the value is 100. Now, the price of that 100 rupees will go down because it’s just offering 6.3 or 6.5% vis-à-vis 7%. So that’s why in the current scenario where we expect the interest rates to go up because the RBI has been tremendously tolerable looking from the recovery perspective. From all these reasons it may make sense to look at medium term to short term but having said that, I really liked the product in couple of manners very frankly. So, one is, it takes away your credit risk because it’s going into G-secs while the duration is around five to six years, that’s what I understood.

HARSHAD CHETANWALA: Because I wait for the opportunity and when the interest rates goes up, the fund manager also has the opportunity to go and buy or take the bonds which will give you a higher yield and that probably is the time. So, like we say in equities, it’s very difficult to time the market. It’s also similar in the debt market as the interest rate risk will always be there.

HARSHAD CHETANWALA: I would rate them together very frankly, because the nature of the investments is very nearby at the same time the returns that you will expect from both these kinds of investments will be very close. So, I would rate them very close to each other.

HARSHAD CHETANWALA: So, there are basically two points that I’m trying to put forward. The first one is the category which works for most of the investors. That is the flexi-cap category which was earlier known as multi-cap. So, that’s a category, which does take a lot of allocation at our end when we work for our clients and when we work for their portfolio. This is predominantly for long-term investors who are looking for their financial goals right from five years or seven years and above. So, flexi-cap funds are good because in our view, it gives the option to the fund manager to invest into large caps, small caps and mid-caps in a way and the fund manager has this flexibility to take the call depending on the market conditions. I think this makes it a much easier job for the fund manager at the same time for us who are advising the clients. We have to identify the right kind of flexi-cap funds and then, rely on the fund manager to deliver the returns. So, if you look at that category, there are very good funds, which have been doing very consistently well across the years.

One of the funds that we have identified, is the UTI Flexi-Cap Fund. It could be an unusual choice, but I think this is based on the kind of research that we have done on the fund. This fund has been one of the most consistent or one of the best performers in recent times in the flexi-cap category. While we are not inclined much towards the size of the fund but for people who look at the size of the fund, it is reasonably a very good fund size with around 15-16,000 odd crores. That is the size of the fund. Another important point that we looked into this fund is, this fund has quite well diversified across different sectors. Traditionally if you see most of the peers of the fund will have the highest allocation in financials most of the time, barring I think Parag Parikh where technology is the highest sector. But most of the times you will see that equity based or equity oriented diversified funds will have a higher allocation in the financial sector. This particular fund also has a higher allocation in financial sector but the spread is quite well. We have financials close to around 25-26% and then you have healthcare and technology and then services. So, it is well diversified across sectors, that is one, and two, the fund is not trying to be overweight on a particular stock. So, if you look at the top five stocks, it will be 25% of the portfolio. It’s very important for us to look at the fund in a rising market as well as in a falling market and the year 2020 gave us the opportunity to look at both the sides. When you look at this fund around January 17 to March 23, through the falling phase and then the recovery phase, the fund has done quite well. It has always been in the top quartile within the peers.

HARSHAD CHETANWALA: It’s not that I have chosen this over the others. One of the things is, whenever we put forth flexi-cap we will always have two or three options. So, let’s say a typical investor, if in case you’re constructing a portfolio for the investor, we look at around six to seven funds. Now, in that six to seven funds there will be an allocation of two or three funds into flexi-cap. This is one of those because I presume that your earlier speakers would have covered Parag Parikh and Mirae but I see a lot of merit in covering this fund also.

HARSHAD CHETANWALA: I would say on the equity side, if I have the choice, I would have said Mirae Asset Emerging Blue Chip but unfortunately that fund only takes SIP up to Rs 2,500. Then, I would go back to the usual talks about Parag Parikh Flexi-Cap Fund and I may also have an option of adding Mirae Large Cap Equity Fund. So these are the two funds, which do come under our recommendation when we try to construct the portfolio for our investors. I think most importantly is not just how consistently they have performed including UTI flexi-cap, how they have performed during a good phase of the market and the bad phase of the market. That shows the quality of the fund management and the stocks that they hold.