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Debt market volatility and your investments: Here's what experts have to say

Debt market volatility and your investments: Here's what experts have to say

The storm surrounding the fixed income market finally seems to be settling. While liquidity seems to have returned and the crisis in the nonbanking financial companies (NBFC) sector is more or less contained, there have been questions about the kind of securities that your debt fund money is parked in.

Lakshmi Iyer of Kotak Mutual Funds, Ashish Shanker of Motilal Oswal Private Wealth Management and Vidya Bala of Fundsindia.com help clear doubts and identify some of the debt funds that are worth looking at.

Watch the video here:

Edited Excerpts:

Lakshmi, opening thoughts from you.

Iyer: Though the last couple of months have been a huge roller coaster, despite that if you just look at the tracker and across the fixed income categories, right from liquid to duration categories, not a single category has actually given you a negative return on a one-year basis.

While I am talking about short term because in debt long term is actually three years to account for the long-term capital gains (LTCG) and in three years these numbers look even better.

Yes, there has been a very tumultuous ride, the point is I have witnessed theme parks across the world but I have never seen a roller coaster - it might start you inverted but it brings you to straight. That is very critical when investors are making investments even in the bond markets. It is very natural to see some volatility and some could be high-end volatilities like the ones that we just saw about 6-8 weeks back. However, staying the course is very important.

Ashish, your thoughts?

Shanker: Last three months have been very stressful for a lot of clients, these crisis periods are a stark reminder that if you don't stick to the basics of investing, you could run into accidents.

There are two to three ways you can make money from fixed income - one is, you put it in a fund and you stay invested for the period for which the fund is invested for and you make your interest. Second is, you take a call on interest rates and the third is you try and invest in a fund which tries to take a little bit of credit risk, that goes down the credit curve and makes a little bit of extra money. Whenever you short-circuit this process, let us say you invest in a fund which is meant for three years but you try to take a call for a year or for six months, we have seen that the market always reminds you during this crisis that it is not the right thing to do.

Lakshmi, can you simplify this for us because we also end up jargonising a lot. Investors, retail audiences would have heard these terms - NBFC, DHFL, who is investing in what. So, break it down to the basics for us. As a retail investor who is investing in one of your funds and one of your peer group funds as well, obviously apart from government securities (G-Secs) and some of that paper, there is a lot of other corporate paper that you are also investing in. So, when it comes to risk grades, what is it that the investor should know, what are the questions that an investor should ask before parking money in a fixed income fund?

Iyer: Firstly let me clarify that NBFC is not a bad word. It has got a tag of a bad word but it is not, there are other bad words which people use. You cannot say that this sector is risky or this sector is less risky. I think it is the underlying business that determines the colour or the texture of the risk that one takes on the business.

In that again you have market leaders, for example, like NBFC is a bad word, people often ask me that you have real estate in your portfolio? Real estate again is a pariah in this kind of market scenario. My point is that there is no such thing. That is where money managers have an astute role to play where they kind of cherry pick. In equities we do bottom-up stock picking, it is our onus as money managers to do that keeping in mind the overall economy and therefore have an overlay of the top down.

Vidya, your opening thoughts on whether the storm has entirely settled and what kind of queries perhaps you would have been receiving from investors as well on debt funds?

Bala: The storm hasn't entirely settled. People are a bit rattled by the risk emanating from both sides, that is from credit as well as duration. The reason for investors getting psyched by this is basically because most investors in our experience tend to view debt funds like fixed deposits (FDs). While they get the idea that they cannot expect fixed rate returns, they don't get the idea that they can be volatile, returns can go down too and you need to know which class of debt funds to pick to get the returns that you want and the risk that you want. So, that is where the fundamental problem comes from.

For example, last year many investors going by the returns in dynamic bond funds invested in it and really hurt themselves. Remember the timeframe here was not really long, so that was the problem. They thought they could have a one-year exposure or a six month exposure to a dynamic bond fund and got hurt. Similarly, you don't enter credit risk funds with the idea of taking a 3 or 6 months exposure thinking it is an accrual fund because even if one of the paper fails there, you are going to take time to get back the money. So, these are micro issues that investors find it hard to understand and that is where timeframe based investing comes into play.

It's important to know your timeframe and then to invest accordingly. So as we start with this exercise, let's just rewind back and go over the basic concept. If you are getting into a fixed income fund you need to be aware of 2 things - accrual and duration and decide or ask your investment advisor or help you decide which of these two strategies that you need to be in. As Vidya mentioned that there are people who didn't understand this difference and probably ended up going into a dynamic bond fund for 6 month-1 year and then you end up with losses. Let us look at the interest rate sensitive category, the dynamic bond category or the duration category. On duration what is it that you are telling investors?

Shanker: I strongly believe that dynamic funds cannot be the core allocation in a fixed income portfolio because by nature it is a volatile product and it will move depending on the interest rate view as well as the actual interest rates. This is something that people need to understand, but for somebody who have been investing in fixed income fund for a while, namely a seasoned investor, he could take some exposure in dynamic bond fund if he believes that RBI is going to cut rates because what typically happens in a bond, if the interest rates go down the bond prices go up and vice versa.

So, a dynamic fund would benefit in an environment where interest rates are generally going down, but I would still not recommend dynamic bond fund at this point in time because the overall interest rate scenario is still very muddled; they should probably stick to the plain vanilla accrual funds; funds with -3year maturity.

We were discussing risk profile and you put government securities right up; AAA, sovereign least risky but from an investor's point of view it can be very risky because interest rates vary, there is no risk of default there because it's a sovereign. There is a time risk, there is an interest rate risk. So how does an investor understand this?

Iyer: Essentially, what the bond investor need to understand is that there are 3 types of risks when you make an investment into fixed income category. One is the interest rate risk and second is credit risk and last but not the least the liquidity risk.

When you invest in debt mutual funds, you are in a way outsourcing the liquidity risk because you usually have daily NAVs and open-ended funds but the interest rate risk and credit risk is something that you have to bear with you, you don't have a choice. I think that is where the Gilt funds will score high.

I completely agree with what Ashish said that the volatility will be too unnerving because that is the primary market. This market trades Rs 80,000-90,000 crore in a single day. So you can imagine the kind of volatility it can have associated with it on the upside as well as on the downside. So in a plain simple terms and we can start with food examples, you can have curd rice and that is your simple ordinary debt funds on the shorter end and then you have curd rice garnished with some pomegranate and those are your ultra-short kind of funds and then you go into high-end garnishing by adding cilantro, mustard and all those things and those are your little bit but I am still calling it curd rice because it will still not upset your tummy.

So I think bond funds or fixed income funds should be treated like these curd rice dishes but you can garnish it and spike it with whatever you like just to make it a little bit more palatable but spike it only as much as you can take intoxication.

Give us your thoughts on accrual as a strategy and whether you think that makes perfect sense for you and how do you go about explaining it to the people who come in over there?

Bala: Over the years what we have found is that investors understand accrual far better than duration strategy because the volatility in duration is quite unnerving for them. So explaining accrual is easier because you are able to take the interest of the underlying instruments basically the yield of the portfolio and explain to them that is the returns that they would get where they have to hold the funds for the average maturity of that fund plus the expense ratio is roughly what you should get plus or minus the capital appreciation or capital depreciation that might happen in the portfolio because of interest rate movements.

So once investors get a grip of the yield, the yield to maturity is a technical term but we try to explain that's the coupon that the underlying instruments get. So once they get a grip of that try and compare it with what is available outside with your FDs or with the post office and see if this makes sense to them. Of course, within that there is a range, there will be yield to maturity with 8 percent and those with 10 percent. We try and explain to investors that those come with a bit of risk. The credit risk funds give that higher yield to maturity and short-term, AAA fund etc. gives lower yield to maturity. So that seems to be the simpler way for investors to understand that the interest accrues over the period of the maturity of the underlying instruments and you need to hold the said fund for at least this period of time that is the average maturity period in order to get those returns. We have been reasonably successful in explaining to investors this concept.

This is where it gets interesting because now you are not looking at funds which are only investing in government bonds but the funds that are investing in all kinds of paper. It could be corporate, NBFCs as you mentioned and here the concept of risk becomes important because while a lot of it is sold -- your FD is giving you only 7 percent, look at this fund, it will probably give you 9-10 percent. How does an investor go through the risk profile? It is very difficult to look at the whole list of securities and then read through and these days AAA may no longer be AAA the next day when you wake up. So what is the advice here?

Iyer: Two distinct features which one need to bear in mind is that why do Gilts have volatility because they are inherently longer duration. The government tries to borrow long whereas most corporate India tries to borrow short to medium-term. So therein where the underlying of maybe a credit risk fund or a corporate bond fund where the usual maturities, give or take a few years here or there, you are investing either in one year bond, two year bond, three year bonds, upper end of five year bond. So that is your spectrum. Now the risk associated, as Vidya rightly mentioned, there is an element of credit risk, there is no free lunch, right? But the beauty is that mutual funds offer diversification; so you have 30 stocks, 40 stocks and 50 stocks and if luck would have it if India matures even more then we will have 100 stocks in a portfolio of fixed income.

So therein lies a risk diversification. Yes, there is no free lunch. What you need to know as an investor is that these risks are inherent to any fixed income investing. Unless there is a credit loss, no investor will lose his or her capital in fixed income investing. So that is fundamental and last but not the least all this is not 'Googleable'; for everything people think its Google. I think you need an advisor, you need an astute financial advisor by your side who is just eating, drinking and breathing all of this.

In my own experiences I have seen IFAs come out and only talk about the good side, the fact that this is a fund that is going to give you may be 2 percent or 3 percent more than your fixed deposit but there are questions on the other side - the risk side that one needs to ask, these are credit risk funds and that is why the regulator has now rightly changed the nomenclature to credit risk. Earlier, they were called credit opportunity funds but with it there is also a risk. Another part of the recent storm has been the kind of securities that are going in these funds. There was a controversy about whether there are certain well-known promoters in the market or well-known individuals and whether bonds issued by them are bonds that mutual funds subscribe to, whether they are collateralised or not, so then as the end retail investor is my money being out to risk?

Iyer: My sense is that the financial world is no different than Bollywood. Padmavati was a controversy but the moment you made it Padmaavat it was acceptable. So, controversies are part of life, it is going to be part of financial markets also. My only underlying submission is that no mutual fund in the country is investing which is not legal. What I am trying to say is that everything is either backed by a collateral or it is unsecured, there can be only two things. So, I am buying a bond, it is backed by some strong collateral or security.

As an investor when you borrow money from a lender, you have to pledge your house or you have to pledge something, so that is very simple or it is unsecured, there is nothing illegal happening in the mutual fund industry. There are some black sheep's, now because there is one or two black sheep's, the entire herd is absolutely not bad.

Typically a credit risk fund would invest in how many different securities? In a portfolio of stocks for a midcap fund there are at least 30-35 stocks or 40 stocks, so in a credit risk fund what is the level of diversification? If you are exposed to one entity or one NBFC or one promoter, is it capped at like may be 2 percent or 3 percent or 4 percent, what are the usual parameters?

Iyer: While the regulatory cap is at 10 percent, if you see most of the diversified credit portfolios or corporate bond portfolios, they range in the band may be 2-4 percent. So, it is a fairly diversified portfolio of at least 30-40 stocks. So, it is not a concentrated strategy. Guild funds are concentrated because there are fewer guild's that you can own in terms of liquidity also. However, diversified portfolios within the corporate bond space and credit risk is a reality which as I said the investor may or may not be aware.

Ashish your take on credit risk and credit risk funds?

Shanker: I just had a couple of points to add, when you look at a credit risk fund, there are three things that you need to keep in mind. One is the granularity of the portfolio. Direct investing today has become very popular. If you are just going and buying something like a fixed maturity plan where you are matching your time horizon to the underlying portfolio, it is an easy one but the moment you venture into the world of credit funds I genuinely believe that your advisor can add value.

A credit fund you should look at the granularity of the portfolio which means the concentration of the fund in any particular security should not be more than 3 or 4 percent because unlike duration credit risk can be binary which means you can lose 100 percent of your capital. Normally, it does not happen, you get 60-70 cents on the dollar as we have seen in some of the earlier cases. The second thing you need to be cognizant about what is the maturity of the portfolio? Is it two years, three years? You come into a portfolio which matches your time horizon and then the last thing that you need to look at is the yield to maturity, which is the interest you will make if you stay in that fund for that duration.

Here again, you should be cognizant of the fact that there is a gross yield and there is a net yield. The difference is essentially the expense ratio, the charge that the fund is levying to manage the money. Now what the investor ultimately gets is the net yield to maturity. Now, this is again a concept that is not very well understood.

Most people publish gross yield to maturity and investors think that is the yield they are getting. So, these are three things that are very critical when you choose a credit fund. Thankfully, because of SEBI, after the classification changes the funds are named appropriately.

It is very important first of all to realise whether you are in it for the long haul or the short haul and then decide between duration and accrual. What are the first steps as you are looking at creating a fixed income portfolio. You want to get away from fixed deposits. How do you start?

Shanker: The first thing in fixed income I would like to highlight that do not chase performance because in fixed income the last one-year performance means nothing. Just because the fund has done well in the last one year doesn't mean that performance is going to continue.

It is far more qualitative an asset class. So first you got to look at what your time horizon is, match your time horizon with the appropriate fund. So if your time horizon is four years, you could buy a fund which has 3-4 year maturity or you could even go in for fixed maturity plan if you know that you do not have liquidity requirements before 3 three years and after three years what happens is that you get a much bigger tax advantage. So for an HNI who is paying 30 percent plus tax on a bank deposit, the moment you come into a fund the effective tax rate after indexation comes down to 7-8 percent.

That is when it starts making sense for a lot of the middle class investors and retail investors as well?

Shanker: Absolutely and for most investors, if you have a horizon of fewer than 3 years or less than 1 year or 6 months, you have funds like liquid, short-term, match your time horizon with the maturity of the fund. So keep it simple.

What kind of debt funds are you recommending to clients at the moment?

Bala: Over several interest rate cycles what we have observed is that the ability of investors to stick to duration has been very low, especially retail investors. So coming to your question on what we recommend at this point in time, once again basics based on their timeframe, we ask investors to stick to quality liquid funds and ultra-short-term funds. We make sure that there is no concentration risk and the credit quality is absolutely high here, there is no place for lower credit when your timeframe is short.

The funds right now in our list are Axis Liquid, HDFC Floating Rate or Aditya Birla Floating Rate and so on. When it comes to longer-term investing, medium accruals strategies; here again sticking to quality papers is ideal for those who are just making the shift from FDs. A quality fund like HDFC Corporate Bond, Birla Sun Life Corporate Bond ensure that they do not give any shocks to people by way of paper being downgraded sharply.

For those a little more discerning investor who wants that extra bit of yield, slightly higher risk; we, in fact, do not go to very high credit risk funds, for example, a fund like UTI Medium Term, it's actually a medium duration fund under SEBI's category but it does have some qualities of credit, not as much as credit risk. Now that amount of risk in our opinion is sufficient for a retail investor to get that extra bit of returns over his FD. So these are the kind of accruals strategies we are giving right now.

If you could name some funds as well. You mentioned the broad contours but the kind of funds you would be recommending?

Shanker: Anyone who is looking at investing money for 3 years plus, we are recommending high quality accrual strategies at this point in time. So we have Axis Banking PSU Fund, IDFC Banking PSU Fund. I think even Kotak has banking and PSU funds. These are essentially funds which are investing in highest quality papers and the maturities are between 2-4 years.

If I am hungry and I feel like having a fixed income meal. So let us go back to that example, what is the curd rice, is a basic accrual fund the curd rice and what are the add-ons there?

Iyer: If you want just a liquid fund, no risk at all, you have just steamed rice. Then you want a few additional returns compared to the liquid funds, you have a 3 to 6 months kind of investment horizon, then you have jeera rice which is little bit spiked with jeera, tastes good. Then you have a peas pulao which is typically the short duration funds. Anything under one year is typically jeera rice, so you stick to ultra-short term kind of funds. The moment it comes to a little bit of more veggies getting added then the horizon should be north of one year, ideally at least three years.

1 to 3 years basically?

Iyer: That is right, the short duration funds clearly play that role. Then if you want to have the exotics but before that the curd rice has to come somewhere in between but that will be a combination of medium term funds and corporate bond funds, the PSU bond funds etc. Then last but not the least you have the Hyderabadi Biryani which is with mirchi ka salan kind of a thing and that is the combination of credit risk and the duration funds, one with credit risk that is where the mirchi ka salan comes in and then one with just the Biryani if you just want to have a palette for the Hyderabadi Biryani, that will be the duration because it will come with the exotic veggies as well but it can give you pains like the ones we saw may be a couple of months back.

So, make sure you have a long time horizon to digest the Biryani?

Iyer: Absolutely because they are carbs, right?

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