With a large portion of rate cuts behind us, investors may not earn double digit returns from debt funds like they did in the past. Avnish Jain, Head – Fixed Income, Canara Robeco Mutual Fund, shares his outlook on interest rates and why investors should stick to quality even if returns are moderate.
Do you see the policy rate at lower levels for a foreseeable future?
We believe rates will remain low for reasons like slowdown in gross domestic product, or GDP growth, and the uncertainty surrounding the vaccine. It will be a slow and laborious growth, especially in worst-hit sectors like tourism and entertainment. Federal Reserve has pushed back stimulus. So the policy rates will remain lower for one or two years in India.
Do you see any scope for further rate cuts?
There is room for 50 basis cut in policy rates but the Reserve Bank of India, or RBI, is unable to take action due to higher inflation. We see inflation falling in the last quarter of FY21. It is likely to remain below RBI’s target for the first quarter of FY 21 which could lead to a rate cut.
How does a low policy rate scenario impact debt fund investors?
The returns over the long term may come from portfolio yields. The five year G-Sec is at 5.25%. Short duration and corporate bond funds invest in typically shorter maturity paper like G-sec and public sector utility, or PSU, paper. If the investment horizon is 4 to 6 years, you will go for high-quality paper. So your return expectations should also come down to a similar level over the longer term.
Is it time to move out of gilt funds given that we are at the fag end of a rate cut cycle?
Similar to equity markets, it is not wise to predict your entry and exit in gilt funds. If you look at returns over the long term, and compare with equity markets, over a five year period, gilt funds have delivered 9%, outperforming Nifty and some diversified funds. Markets are going to be volatile. Allocation to gilt funds is a must if you have a five-year horizon. Even ten year returns of gilt funds are over 8%. In gilt funds, investors face interest rate risk if the rates move up. Such funds could deliver low returns over six months to one year period when rates go up.
Nobody wanted to invest in gilt funds till the policy rate was 6.5%. The market was different at that time. The inflation was high. For an economy that is growing and developing, we know that over 15-20 year period, rates have to come down. Otherwise, the economy can’t grow. Going by this assumption, you should hold on to your gilt funds. It doesn’t make sense to switch from gilt to short duration. Historically, the spread between repo and ten year, has been around 70-80 basis point. This spread is 200 basis point now. Market has factored in the large borrowing by the government this year. Even if there is no rate cut and RBI stance becomes neutral, you won’t see yields spiking because the yields have not fallen off so much for them to rise. We should now see some stability in the G-sec market because the market has been steady for three to four months owing to a larger supply. I see no reason to move out of gilt funds.
What are the risks involved in gilt funds which retail investors should be aware of?
Investors first tried out credit risk funds in 2011-12. During the 2008 global financial crisis, credit was a small part of an investors portfolio. There was little sprinkling of credit in short duration and liquid funds. The industry came out unscathed. After 2009-10, credit started doing well as governments pumped money. People have experienced large volatility in gilt funds because they saw a drop in 2008, rates rose because of extra borrowing in 2009. When someone gave them higher-yielding portfolio for 1.5-year duration, investors started shifting from duration to credit. Besides credit risk, investors are now exposed to liquidity risk as well. After the shock in credit risk funds, a lot of large investors shifted to gilt funds and long duration funds. Gilt funds are good for retail investors as there is no credit risk. There is just interest rate risk.
From the recent episodes in the debt market, we have observed that the recovery process from defaulters can be very challenging. What is your opinion on this?
We were among the few fund houses that dint go overboard on credit. Our position was clear since 2012 that we will have only a moderate exposure to credit. I had been indicating that credit risk is just the tip of the iceberg. It comes with liquidity risk and legal risk too. Despite The Insolvency and Bankruptcy Code, or IBC, the process of recovery has been slow. Fund managers invest with a three to four-year horizon, but investors can get out of funds in one day. So there is a mismatch. Our liabilities are much shorter. There is no exit for credit paper in India. You have to let it mature and hope for the best. IL&FS case is still dragging on. You might get money after five years but in between, you lose five years of interest. It is a huge cost. At this juncture, investors should not take any credit exposure. If someone is sure about a company, then it should be in moderation. The legal process through court has always been slow.
Retail investors often get stuck in funds while large investors exit early when there are signs of danger. How can retail investors be protected?
The Securities and Exchange Board of India, or SEBI, is working hard to ensure that retail investors are protected. That’s why it introduced graded exit loads in liquid funds for seven days.
Going ahead, there are expectations that the regulator may come out with a swing pricing mechanism. It is already prevalent in the western market. This is how it works. Large investors have to pay higher than NAV and get less than the current net asset value, or NAV, while exiting, which could be based on the quantum of inflows/outflow they exercise, which is usually a percentage of the NAV. If the net inflow exceeds this swing threshold, the NAV is swung up. If the net outflow exceeds this threshold, the NAV is swung down. This practice ensures that trading costs associated with large inflow/outflow are borne by the subscribing or redeeming investor rather than existing unit holders in the fund.
In the current scenario, what strategy should investors adopt while constructing their fixed income portfolio?
Money should be spread across duration based on investors risk appetite and investment horizon. If you have five-year investment horizon, you can go for gilt funds, corporate bonds and shorter duration funds. Stay away from credit risk funds because the economic health is not sound. You can’t expect weaker companies to bounce back swiftly. Stick to quality even if returns are moderate.
