A few categories of debt funds have delivered double-digit returns due to a downward trajectory of interest rates and abundant liquidity. R Sivakumar, head of fixed income at Axis Mutual Fund, believes that the rate cut cycle may not continue further and hence investors should moderate their return expectations going ahead.
Debt funds can be complex for lay investors. What kind of funds an investor should ideally hold all the time in their portfolio to achieve full diversification in debt asset class given that there are 16 categories?
Investors core portfolio should consist of low duration products – one to three-year duration. Investors can also hold medium duration funds. Funds with a duration of up to three years are good from a risk-reward perspective. Investors should start building their debt portfolios starting from these funds. Within this category, investors have a choice to go for either AAA portfolios or take some credit risk. There are funds which offer a mix of both.
Liquid funds can be used to park money for days or a few weeks. When building a debt portfolio, the need for precaution is one aspect. You have to also look for generating tax-efficient medium-term returns over and above what liquid funds can offer.
What about dynamic bond funds?
Dynamic bond funds category has a wide range of strategies across different fund houses. The regulator has given leeway to fund houses to decide their strategy in this category. Investors may not necessarily discern them. Only savvy investors who understand the fund’s strategy and risk should consider these funds.
Corporate Bond Funds and Banking and PSU Funds are gaining a lot of traction lately. Do you think these two segments will continue to offer attractive yield going ahead given the growing interest in the category?
Most of these funds also fit in the short to medium duration fund mentioned earlier. The funds have generated attractive returns due to the extraordinary rate cuts and abundant liquidity in the market for over 1.5 years. Short term bonds with AAA portfolio have been the biggest beneficiaries of these rate cuts. The yields on these AAA bonds have now fallen to around 5%. Moving forward, investors should moderate their return expectations.
What would be your advice to investors who are lured by past returns from these funds?
Investors should not be swayed by looking at the past returns, especially in debt funds. A series of rate cuts, especially when you are at the fag end of the rate cut cycle, the past performance always looks strong. As the rate again starts to move back up, such attractive returns cannot be repeated. In the same vein, when the rates are at their peak, it is actually the right time to invest in debt funds. But the past performance may not look attractive when the rates are at peak and investors tend to shun debt funds. Investors should look at portfolio composition and yield while investing in debt funds.
Funds with AAA-rated portfolios have outperformed in the last one to two years. That’s not a reason to buy those funds now.
The credit market has had a difficult environment, especially in the non-AAA space. As a consequence, the spread between AAA to non-AAA securities has widened. The spreads have widened to the levels witnessed in the 2008 crisis. It is unlikely that these spreads will widen further from here. It makes sense to invest in an active strategy that also takes exposure to non-AAA rated paper depending on investors risk appetite.
Credit risk funds continue to see outflows, though the quantum of redemptions has reduced lately. Do you think it is the right time to consider this category for savvy investors with a higher risk appetite?
The valuations are very compelling based on the spreads in the non-AAA space. In the last four months, large companies have weathered the storm better than smaller businesses. As you go down the credit curve there are two things investors should keep in mind. In credit risk funds, the typical allocation to non-AAA is 65% plus. There is a cap of 25% on sovereign, AAA and AA-plus securities. So there is a higher weight towards the riskier segment of the market. The second aspect is selection and weightage given to securities. You have to look at the diversification across sectors, groups and companies. An alternative way to participate in this market is through funds that are not classified as credit risk funds but take minimal exposure to non-AAA rated securities.
In a scenario when policy rates start rising, what kind of funds should investors take exposure to?
Short duration funds benefit when rates go up. When rates rise, there is a mark to market loss as bond prices rise. Short duration funds benefit by reinvesting the proceeds from the maturity of short-term holdings at a higher prevailing rate. While short-duration funds can hold securities up to three-year maturity, they can cut the maturity to one year. Such funds benefit from a rising interest rate environment over a three-year holding period. Investors should not worry about the interest rate cycle if their holding period is three to five years in short duration funds. The performance could lag over six months to one year. However, over a three-year period, the fund benefits in a rising interest rate scenario.
If you invest in long-duration fund with say seven-year duration, that will hurt in a rising interest rate environment. If you are keen to invest in long-duration funds, invest in funds that have a roll down strategy so that duration comes down over a period of time. Let’s say for a long duration fund, at the end of five years, the residual maturity will be 3.5 years. Therefore, the mark to market risk at the time of exit will be lower. If you wish to capture the yield curve opportunity at this juncture, invest in a fund with a roll down strategy rather than a pure long-duration fund.
How does an investor benefit from a roll down strategy?
Let’s assume there is a 1.5% spread between 3-year AAA and 10-year AAA securities. If you have an investment horizon of three years, by buying a 10-year bond you are earning 3% to 4% higher yield for three years. At the end of three years, the residual maturity will be 7 years and the residual duration will be 4 years. If you have already captured up to 4% higher yield, which means 0.5% to 1% rise in interest rate in that environment can be absorbed even if yields move up. You will still make returns akin to a three-year duration product. Up to 1% rate hike in the next three years is already priced in the market. The risk is only if yields rise by more than 1%. If you’re holding period is five years, it is even better because you would have earned 5% to 7% and the residual duration will be three years. Even if yields drop by 1.5% to 2%, you are still better off buying a long-term fund. At this juncture, long-duration funds with roll down strategies are very advantageous for investors with a horizon of at least three years or more. Retail investors may not be able to identify which funds in the industry are following a roll down strategy, so they should consult a financial adviser.
