The Mutual Fund Show: What Should Debt Fund Investors Do As Yields Rise?
The White Box gallery in New York (Photographer: Jennifer S. Altman/Bloomberg News)

The Mutual Fund Show: What Should Debt Fund Investors Do As Yields Rise?

Rising yields impact both equity and debt. Long-term investors in debt funds, however, can ride out this phase, according to two investment advisers.

Headline inflation close to 4% gives the Reserve Bank of India a little bit of extra elbow room to keep the interest rates under check for now, said Mahendra Jajoo, head of fixed income at Mirae Asset Global Investments Pvt. But yields may rise in the second half of the year, he said.

When yields go up, there will be some adverse impact on the NAVs of debt funds, he said. Those invested for the long term and willing to sit through one complete interest rate cycle just need to wait it out for tax advantages, he said on The Mutual Fund Show.

Vijai Mantri, co-founder of JRL Money, said for those looking at two- to three-year horizon, the starting point is to look at corporate bond and interest-sensitive debt funds in a very gradual manner.

Options For NRIs In India

Non-resident Indians have the option of investing in all the mutual funds, with a small exception of citizens of the U.S. and Canada that have a specified list of funds which accept investments from NRIs.

Mantri advised NRIs not to invest in international funds citing additional currency transaction costs. And they also need to be aware of taxation of debt and equity funds.

For more, watch the full show here...

Here are the edited excerpts from the interview...

Mahendra, rising yields across the world—equity markets seem to be baking in some fluctuations and multiple corrections because of that. How should an average mutual fund investor in the non-equity side think about this phenomenon?

JAJOO: The global bond yields are moving up in anticipation of the inflation coming back into the system, the difference this time, unlike the last 10 years where the excess liquidity in the global system was largely a function of the monetary policy-led quantitative easing, this time there is a huge fiscal expansion. Even the conservative countries like Germany and Singapore have 20% fiscal deficit. So, the market is expecting the bond yields to go up in anticipation of inflation. Also, in the last Federal Reserve meeting, the Fed did not endorse the market’s expectation of extending the maturity of the bonds that it is buying under the quantitative easing programme. So, there is a sharp rise in the bond yields globally. As far as India is concerned, overall, the global monetary policy setting is favourable for whatever it is worth. The headline inflation has come close to 4%. So, I think that gives the Reserve Bank a little bit of extra elbow room to keep the interest rates rise under check for now. But the weight of the large government borrowing programme and the fact that the corporate credit will pick up if the economy is to grow at 10%+, there’ll be a bit of a crowding out of corporate borrowing programme. It is possible that in the second half of the year, we will see rising yields. Now, when yields are rising, obviously the investors will factor in as to how their investments can get affected. Needless to say, that when yields go up there will be some adverse impact on the NAVs but for people who are long-term oriented in nature, who are willing to sit through one complete interest rate cycle, I think they just need to wait it out for long-term benefit to have the tax advantage etc. So, like in an equity market when it corrects, we say that it is an opportunity to buy because the valuations have become attractive. We look at the fixed income in the same way and say look, if you think that yields are going up it is an opportunity to buy new bonds at a higher yield, especially when the corporate rate demand is expected to pick up. The large, good companies will be borrowing at higher rates because their business is growing. So, all in all, there is an opportunity to not look at it in a negative way but as an opportunity buy in correction. That’s how we look at it.

Vijay, what is your view here?

MANTRI: So, we have been consistently saying that interest rates in the global market and in India will go up, and in the beginning of the year we said investors should stay in the lower end of the curve. Now we have seen that interest rates have moved up of 10-year G-Sec. That’s a 50-basis-point move which I think is very decent. So, I think if one is looking at a two-to-three-year horizon, perhaps this is the starting point to look at corporate bonds and interest-sensitive debt funds but in a very gradual manner because the best time to invest in debt funds are when the returns are looking negative and not when the returns are looking positive. It is very discomforting when you start investing but I think that it’s the best way to look at investing in the bond market. So, one can start making very small exposures in the corporate bond fund and the advantage Mirae perhaps would have is that they are starting now and so in the beginning, the portfolio duration will remain short, they will get new money which will get invested with a higher interest rate. So, one could start with a smaller allocation and then see how the interest rates move and then take a call on a periodic basis. As you understand, interest rate calls are much more difficult to take than the equity market calls.

Mahendra, can you talk a bit about the NFO? What’s the rationale of launching this NFO at the current juncture and what kind of investors should apply to this NFO and what kind of returns can be anticipated?

JAJOO: In our view, the government borrowing programme is rather large and the expectation is for the economy to grow in double digits, which means at some stage the corporate credit demand will pick up. Right now, we have a lot of excess liquidity in the system. And as the corporate credit demand picks up and a lot of this liquidity will filter through the broader economy which will cause a bit of inflation. The higher borrowing will put pressure on the bond yield. So, in the next six months, we’ll possibly see a situation where large high-quality corporates will be there in the market to borrow at attractive levels. So, that sets a good ground for building a good, high quality portfolio. Obviously, the best opportunity to build a portfolio is when there is a good supply at attractive valuations. So, from that perspective, we think it’s a good time. In terms of the credit quality of the portfolio, we look to restrict ourselves to high-quality credit, AAA, AA+ bonds, government bonds and treasury bills to manage liquidity and innovation targets. So, all in all, this looks like a very opportune time for someone to start building a portfolio in this kind of a fund.

What are the risks to an average investor?

JAJOO: There is always a risk of short-term volatility or decreased returns because obviously when you are buying at a time when the yields are going up, obviously, there is a short-term concern that for a while the returns may look negative but as I said that we have to look at it in terms of the market cycle. We have seen it historically, and I think Vijay was also saying the same thing that the time to start building the portfolio is when the yields have gone up. We will be investing in our fund in a gradual and in an incremental way assessing the market conditions because we follow a flexible interest rate strategy where we look at the valuations appropriately before we start chipping in from the market. So, the risk is primarily of interest rate volatility for the period during which the interest rates may reach up. In terms of the credit quality, we are going to focus on the high credit quality. I believe that the risk is largely for the investors to be prepared for a bit of a patch of volatility. Beyond that I don’t see it as a risk but a good opportunity to lock money for the long term at higher yields.

Vijay, from a perspective of somebody who’s looking to invest in these kinds of funds, is Mirae NFO a good option or are there other options or do you think there are better categories than the current category that is being on offer?

MANTRI: Right now, most of the money has to be in the lower end of the curve so perhaps liquid is the best category right now because the month of March is coming and in the month of March interest rate generally goes up for various reasons. So even if someone want to take exposure to ultra-short term, the best time to look at it is the first or the second week of March. Then one needs to look at the interest rate very closely because the commodity prices have gone up — soft commodities, hard commodities, oil, everything is up anything between 50% and 100%. So, there is no reason that interest rates would remain at the same levels at least in the global market. In the Indian market, the interest rate has not come down that dramatically. So, the rise will also be very limited in my opinion. If one is looking at building the corporate debt portfolio, perhaps start looking at biting it a little bit. You are in the first leg of the journey. So, over six months to 12 months, it will be a fantastic time—if you are looking at building the book on the debt side, the next six to 12 months may provide interesting opportunities.

Didn’t I see a tweet from you which said that liquid funds might not be the best option? Fixed deposits might give you a better return?

MANTRI: I said if you get 4% savings accounts rate and interest rate in the liquid fund is 3.25%, that doesn’t make any sense for whatever reasons. If you’re an individual, and if you get anything above 3.50% in the bank deposit, keep that money in the bank deposit you also get separate deduction in the Income Tax Act up to Rs 10,000 interest every year. What is most fundamentally interesting thing to see is, suppose you want to invest money from liquid fund to equity fund, if we do it today after Feb. 1, 2021 then you get the NAV of the next day but suppose you have money in a bank account, then you can get the NAV of the same day. So, it make tremendous sense to not to keep the money in the liquid fund—the money which you are keeping to park in equity on the timely basis. If interest rates in the economy go up and liquid funds start delivering 4% kind of returns, that perhaps is the time to look at owning liquid funds and not in the current environment because in the current environment, suppose your saving bank offers you 3.50%+, then keep your money there.

But compared to the funds on offer, the liquid might be a better option currently?

MANTRI: Yes, liquid might be a better option. If you look at it, invariably every year in March, yield shoots up on the shorter end of the curve. So, take advantage of that situation.

Can you very tell us what are the options available for a non-resident Indian to invest in the Indian mutual fund landscape?

MANTRI: They can invest in all mutual funds. There are few mutual funds which take money from citizen of the U.S. and Canada and not everybody takes money from the citizens of the U.S. and Canada, the list has been given, the investors can examine that. Beyond that they can invest in all debt, all equities, all kind of investment options. However, I recommend them not to invest in international funds because if somebody is sitting in the U.S. and want to invest in a feeder fund which invests in other countries, they take additional currency transaction costs. If you are outside India and you want to invest in the Indian market, Indian mutual funds provide the best opportunities. But if you are in an international market and you want to invest in other international markets, don’t come through the Indian mutual fund route...

So, both equity and debt investors, people can apply to all of these funds?

MANTRI: Yes, but not only mutual funds. NRIs could invest in real estate, they can invest in PSU bonds, they can invest in indirect PSUs, debentures, NCDs, perpetual bonds, Fixed deposits, anything.

Are there any risks that an NRI investing in an Indian mutual fund should be aware of?

MANTRI: Yes, there a couple of things they should know and they should be aware of. One is that, with the taxation part, they need to be very clear. First, they need to figure out whether the scheme in which they are investing is a debt-oriented scheme or an equity-oriented scheme. It is very important and it is very important to know that equity-oriented schemes are a scheme that the underlying fund only invests in Indian companies only. So, what does it mean that all funds of funds are not equity schemes from the taxation perspective? They may be equity schemes from the risk perspective, but they are not equity schemes from the taxation perspective. The first thing to examine that is, whether the underlying scheme is debt-oriented or equity oriented. Once you do that then figure out whether your investment is short term or long term. In equity, short term is below 12 months and long term is above 12 months. In a fixed income side, below 36 months it’s short term, and above 36 months is long term. So, keep the taxation in mind and also the keep the exchange rate fluctuation in mind when you’re looking at investing as an NRI into the Indian mutual fund industry. If you are owning equity or an equity-oriented fund, then tax rate below 12 months is 15% plus surcharge, which depends on what your taxable income in India is. If the taxable income is below Rs 50 lakh, then no surcharge. If it’s Rs 50 lakh to Rs 1 crore, then various slabs are available. Long-term capital gains tax on equity oriented mutual funds, above 12 months is 10% plus surcharge plus 4% cess. So, invariably what happens is, that the fund house generally takes the long-term capital gain tax, the tax is just below 12%. So, just keep that in mind when you’re investing in the equity-oriented mutual funds.

But when you’re looking at investing in non-equity-oriented mutual funds, keep in mind that anything below 36 months, it is a marginal tax. It means that whatever your taxable income is in that financial year in India, your mutual fund gains on the fixed income side will keep added there and whatever the tax levy falls in, there is a tax applicable to you but mutual fund invariably will deduct 30% tax on your short-term capital gains and deposit with the exchequer. You as an investor can claim it if your tax outgo is lower. When you look at long-term capital gains on the fixed income side which is above 36 months, there are two categories that one needs to keep in mind. Listed debt funds and unlisted debt funds. What are the listed debt funds? FMPs, capital protection-oriented funds and most closed ended fund except ELSS are listed. So, for them, the taxation is 20% plus indexation. Unlisted means, all open-ended debt funds are unlisted and in those categories your tax liability after three years is just 10% on the capital gains and then you have to pay the surcharge or cess depending on the taxable income in India. So, it is a very simple and a straightforward taxation. What is applicable to most Indian investors is applicable to NRIs. They just need to be mindful of the foreign exchange fluctuations when they invest in the Indian markets.

A very important factor that one needs to keep in mind is that, when a NRI invests in India, they take the benefit of foreign exchange fluctuations in their taxations, but it is a too complex subject to explain on your TV show. If any of the viewers are interested, they can DM me on Twitter or they can write it in the YouTube comments.

Vijay, we asked you about a fund that you may believe investors should either look at very seriously or get out of because that fund may not be doing well. I reckon you’ve chosen the fund because of the category and not necessarily only because of that fund. Can you talk a bit about this?

MANTRI: If you look at data of December 2020, most of the actively managed large caps have underperformed Nifty TRI but in the mid in a small category the outperformance has been significant by the actively managed funds. So, if the same fund could outperform in the mid and the small cap, then why can’t they outperform in the large caps? If you deep dive into data you will figure out the most important reason has been that in the Nifty, the contribution of the top five stocks has been very high. So, if you look at data for 2018, the top five stocks contributed to 152% of the Nifty returns. Now, an open-ended mutual fund can’t own more than 10% in a single stock and by default they can’t own more than 50% even in the top five stocks. The reason for the structure is that the market is very narrow. From 2018 to 2020 only two stocks—Reliance Industries Ltd. and Infosys Ltd.—contributed to 66% on the Nifty returns. So, the market was very polarised because GDP growth was not happening and the money was only going onto a few stocks. Now, post the lockdown, the economy has become much more broad-based. The market has become much more broad-based too. So, if you see data from the last couple of months, very clearly, there’s a decent outperformance by actively managed funds. In my opinion, if the economy’s recovery becomes much more broad-based, then in any broad-based economic recovery actively managed funds does a much better job. If you were in luck to have invested in the index fund in the last few years, perhaps it is time to look at moving out from the passively managed funds to actively managed funds.

So, it’s not much of a call as you’re saying on SBI Nifty fund versus SBI actively managed fund, it is a category fund. But if people are invested in the SBI Nifty fund, you reckon that they could move into the actively managed funds?

MANTRI: ...my call is to move money from the index funds to the actively managed funds.

Let’s talk about the fund house or the fund that you’ve chosen from the DSP stable. Why do you like this and what kind of an investor should go for it?

MANTRI: If you look at the last couple of years, we have seen only growth investing as the interest rates have been coming down. Now the important question to ask ourselves is what will happen if the interest rates have to rise? If interest rates rise, then commodities will gain significantly. The DSP Natural Resources and Energy Fund invests in commodities companies, it invests in oil, it invests in gas and it invests in alternate energies. So, my top pick today was definitely the one which has value investing and is DSP Natural Resources fund. It has holding in Tata Steel, in Hindustan Zinc, Hindalco, Jindal Steel, NMDC, SAIL, ONGC and Reliance Industries. So, if you have to play on the interest rates rising, if you have to play on inflation coming back, if you have to play on economic recovery, then this is one of the funds which will do very well. We have we started recommending this fund from September-October 2020 and it’s done very well. We believe that the commodity cycle is generally for a couple of years and not for three-six months. So, for the next couple of years this fund can add significant value to the customers.

How does it stack up against other comparable funds or you reckon this is the best?

MANTRI: This fund very interestingly invests one-third of the money in the international markets where a part of the money gets invested in oil companies and part of the money gets invested in alternate renewable energy. So, it’s a very good combination. Two-thirds is invested in domestic metal mining companies, out of the one-third invested in the international market almost half goes into oil companies and half goes into alternate energy. So, it is a very good mix of the portfolio that this fund has. We have been recommending these funds to investors for the last 5-6 months or so.

What are the risks to this fund?

MANTRI: The risk is that any commodity fund tends to remain very volatile so keep that in mind. But if it remains volatile and the NAV goes down, then don’t worry. In the past also, the fund’s NAV has gone down and you have to wait for a couple of years but when the recovery comes, the recovery comes very fast. You will make money in 5-6 months which you waited for even a couple of years. So, just be mindful of the volatility when you invest in this fund.

The last and standard question, these recommendations that you made, aside of the fact that you would be recommending this to your clients, there are no other benefits that your firm or you yourself get from the DSP stable?

MANTRI: No, we are a mutual fund distributor and definitely we get commissions from all the fund houses when we sell their products. In my personal capacity, I also invested in this fund. So, that’s the disclaimer we can make.

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