'Debt funds for volatile times'

With uncertainty looming large over performances of most asset classes, debt funds offer a safer investment option

Santosh Das Kamath, Chief Investment Officer, fixed income, Franklin Templeton Asset Management, does not see the global economic scenario improving in the near future and foresees market volatility across every asset class. With this in mind, he urges investors to consider allocating a portion of their investments to debt funds.

Retail investors are not too keen on debt mutual funds. What would you like to say to them?
From an asset allocation point of view, investors need to focus on all asset classes, especially fixed income, which is one of the core asset classes. Unfortunately, in India, today most of the fixed income exposure of a retail investor is through bank fixed deposits, which might not provide them adequate risk-adjusted returns. Today, bank fixed deposits are around Rs 42 lakh crore and typically the mutual fund exposure is through equity funds. If we look at the bare facts, the Sensex return over the past 3 years has been 7 per cent CAGR during a period that has witnessed extreme volatility. In financial parlance, risk is volatility and higher volatility should ideally lead to demand for higher risk premiums by investors. If we look at global fund inflows over the last one year, most of them have been into bond funds.

Now during this time period, our short-term income plan returned 10 per cent, with barely any volatility and over the 1- to 5-year period, this plan has given returns in the 8-10 per cent range. So now at a time when every market - equity, gold, commodities and real estate - is witnessing high volatility, it makes sense to invest in a debt fund. In times of high volatility, investors will appreciate a stable potential annual return of around 8-9 per cent.

What makes you so certain that volatility will continue going ahead?
Currently there are just three big economies - Europe, Japan and the U.S. - which account for around 50 per cent of the world economy (on a PPP* basis). Growth is almost negligible in these countries and interest rates are close to zero. On the other hand, you have emerging economies like India and China growing rapidly, leading to capital flows. Obviously money will flow between these two blocks leading to volatility - inflows due to expectations of higher growth, with any increase in risk aversion leading to outflows. Overall, given the very low interest rates across the globe, money is chasing relatively higher yields, leading to increased volatility across asset classes.

For India, our current account is negative, and the positive BoP* is due to the capital account surplus. And there is a possibility that it could turn negative when foreign flows turn sharply negative. These flows will continue till the time all the economies are more or less on the same level of growth. While the fiscal situation in U.S. and Japan is similar to that of the Euro bloc, if not worse, the key differentiation is the nature of the EU and anaemic growth levels that make the deficit situation more pronounced. Overall, we have to see how the situation pans out, because if central banks lose control of the situation, we could potentially have an unsavoury situation of high inflation and debt traps. About 50 per cent of the global economy is running a fiscal deficit of about 10 per cent. As growth comes back, interest rates will begin to rise.

You say you see interest rates rising when growth comes back. Do you see that happening soon? Already in the international press there have been views that the European crisis, especially with regard to Hungary, is highly exaggerated.
I do not see the Euro zone crisis getting resolved quickly, as it is the product of a 16-member currency. Each country has different macro-economic issues with regards to growth, inflation and unemployment rates. Germany has a 5 per cent current account surplus, being the second largest exporter of the world. On the other hand, Greece runs an 11 per cent current account deficit. Yet all of them follow the same currency and monetary policy. It's difficult to have a 'one size fits all' kind of solution. The situation in Hungary might have been more of a 'presentation-of-facts' issue by the officials.

Japan has issues of public debt and slow growth and U.S. has issues of a large and increasing fiscal deficit. All these issues will take a while to get resolved. Until then markets will be volatile across asset classes.

You started off by saying that investors would appreciate a stable annual return of 8-9 per cent. In the Indian context that does not seem too impressive.

This is a good return to deliver consistently over a period of time. One needs to look at the historical performance track record of different asset classes such as equity, gold, real estate, etc. along with the volatility in prices, which will provide the context for stable returns.

When you compare it with the current inflationary scenario, it does appear subdued....
Inflation is a big issue for India. Yes ,it is growing at a strong pace, but so have disposable incomes. If you look at consumption expenditure, it used to be around 90 per cent of personal disposable income around 20 years ago. Today that figure has dropped to 70 per cent, so savings have increased. While expenses are going up, income has increased and net total expenditure to disposable income has come down. Also, unlike in the past, food doesn't constitute a majority of the expenditure (25% vis--vis a high of 50% in the past). While food inflation is high, it has a relatively lower impact on our wealth compared to the past. So the amount that is being saved is higher and not necessarily being used solely for expenditure. Having said that, food inflation adversely impacts households with lower income levels and has social implications.

Milton Friedman said that all inflation is ultimately a monetary phenomenon. So there's a conventional economic sense which says that eventually all inflation is a function of excess liquidity. But in India is it not predominantly due to supply constraints?
I agree that inflation is ultimately a monetary phenomenon. If there are supply constraints and higher inflation, and income remains the same, one tends to alter one's consumption mix to fund the higher prices. In the sense, if one cannot afford a car or higher energy prices, one will take a bus or other means of public transport. However, as money supply is constantly increasing, and one wants to maintain the same standard of living, prices keep going up (until the prices impact demand).

In India, we control inflation by controlling liquidity, raising rates and curbing demand. The Chinese do inflation management by giving credit, rapid execution, low interest rates, high liquidity and excess supply to meet demand. Should we not take a leaf out of their book?
Execution is the key and that is difficult in a country like India with a democratic and multi-party set up, where different constituents have varying objectives. Despite rapid growth, per capita income remains low and majority of the population does not have social security or healthcare benefits. So it's very difficult to pass on, say, the oil price hike to all. What happens to lower income households, if the price of an LPG gas cylinder goes up by Rs 200? There are advantages and disadvantages of China's centrally planned economic model and its political system, and the jury is still out on their sustainability.

In a large democracy like India it's difficult to assume that we will have consistent growth of 9-10 per cent. Whenever growth takes place, there will be infrastructure bottlenecks, inflation will rise, tightening will take place and again it will come down till the cycle starts again. So the economic cycle is unlikely to be smooth. But the overall macro trends at this stage do point towards relatively higher economic growth over the years to come.

Do you think monetising the deficit is the right way out?
As long as we are growing, there is no problem. Public debt to GDP is 75-80 per cent - in India as well as in the Euro zone - the difference being the fast economic growth in India. We do have a fiscal issue, if you add up the centre and state governments' deficits; we have an 8-9 per cent fiscal deficit. And it's not easy for India to control this deficit because of the oil and agricultural subsidies along with interest costs and government expenditure; it's not easy to pull back. The only way out is to probably keep increasing the growth rate so that the percentage keeps dropping. From 2003 to 2008, the combined fiscal deficit came down sharply from 9 to 4 per cent. But this wasn't because expenditure came down, but because GDP expanded strongly. The fear in the Euro zone is that GDP is shrinking and fiscal deficit is going up.

Don't you see India's fiscal deficit as a worry?
As mentioned earlier, it's a manageable worry at this stage. A key parameter is the price of crude. At $85/barrel, the under-recoveries for India will be Rs 1 trillion. For every $10 increase in global prices, this is expected to increase by Rs 250-300 billion. Of course, there is talk that the 3G/BWA revenue will ease the fiscal deficit to some extent - Rs 350 billion of extra revenue has already come in due to the 3G auctions. So now if oil goes up, the fiscal deficit will rise because we import $85 billion worth of oil (30% of total imports) and will not be able to fully pass through the higher prices. So global oil/commodity prices are key factors for a growing economy like India that depends on imports for most of its energy requirements. Also if along with oil prices, we have a depreciating rupee, it would be a double whammy.

Won't a large fiscal deficit crowd out private borrowing?
Over a period of time if growth is sharp and investments by the government and corporates move up sharply, credit availability will be impacted. In India most of the government borrowing is done in the domestic market, while Indian corporates have the option of using the IPO route (if global risk appetite remains favourable) or raising funds overseas to take advantage of the very low interest rates. Last year we had the advantage of the RBI conducting OMOs* and buying securities. Sooner or later when both public and private borrowings increase, it will result in interest rates going up.

Where do you see interest rates headed?
The RBI will raise rates in a calibrated manner - the overall direction remains on the tightening side, but the pace could vary depending on various domestic and global factors. I don't see short term rates rising sharply unless the RBI changes the rates in an aggressive fashion. Recently we saw short-term rates rise because of 3G licence fees payment and advance tax payments. But I think liquidity will come back in the system in July.

Templeton India Income Opportunities fund has been putting up some good numbers. It's a very new fund. What was the thinking behind it?
In 2008, in the midst of the global turmoil and the liquidity crisis in India, there was a huge amount of risk aversion in the system. The view was to stick to G-Secs due to the overall weak environment amidst fears of corporate defaults and downgrades. We felt the fear was exaggerated and misplaced, and hence held a slightly contrarian view. We did not believe that India had a huge amount of credit risk in the system, given that underlying fundamentals remained intact. We were in fact concerned about the huge government borrowings as a result of the fiscal stimulus programmes. So we maintained a very low maturity on our income and debt funds.

At that point of time, we also saw the spread on normal papers widening quite a bit, especially in some good NBFCs and PTCs*. Now these were giving around 6-7 per cent over the G-Sec. So at that point of time, in January 2009, when a 10-year G-Sec was quoting at 5 per cent, we analysed the impact of a further 50 bps cut in interest rates and even after considering the capital gains, we realised that the net yield would be lower than that achieved through a 1-2 year paper held till maturity.

The risk was that G-Sec yields could actually have gone up, instead of coming down. So we were low on maturity and in our short term income plan we had similar paper, which we believed was low credit risk but spreads were high. However, we felt that a retail-oriented fund that can invest in such papers and hold them till maturity had the potential to deliver superior returns due to these high spreads through accruals.

Our Templeton India Short Term Income Plan had begun to grow (from around Rs 400-500 crore to close to the current Rs 6,800 crore). But the fund had a limit of 30 per cent on our PTC exposure. We felt that a fund that can be flexible and where investors can stay invested for a relatively longer period, can reap the benefits of higher accruals. So in December 2009 we launched the India Income Opportunities Fund, which is now around Rs 3,000 crore. We also put in place a reasonably high exit load to discourage short term flows that could prove detrimental to investment strategy. Overall, this strategy worked and the fund has been able to deliver a reasonably good performance since its launch.

Is India Income Opportunities a crop fund?
No. We do not take undue credit risk in the fund; it's more of a call on the spreads. We do not invest in low credit paper for higher yields. In 2009 investors became ultra safe and just bought CDs and PSU* bonds, and we could invest in good credit paper at significantly higher spreads.

Yet the fund does have around 48 per cent of the portfolio in SOs and PTCs as well as a substantial exposure to AA and A rated paper too, not just AAA.
Exposure to structured obligations (SO) and pass through certificates (PTC) does not make the fund riskier. The perception in the market is that these bear high credit risk. Not necessarily. They can be high credit papers and at times even more secure than certain AAA-rated papers, due to the way they are structured. Looking at the historical numbers, the probability of downgrade and default in an SO can be lower than in a normal bond. The fund currently has around 41 per cent exposure to AAA equivalents and around 39 per cent to AA equivalents.

If you only end up buying a PSU bond or CD or G-Sec or AAA paper, what is the point of investing in a fund? One needs to evaluate investment opportunities on an active basis and take exposure on a risk-adjusted basis. We don't take undue credit risk. We never had any real estate exposure at any point of time in our debt portfolios.

In 2007, even when the general perception of real estate was very positive, we didn't pick up any of the paper, because of our concerns regarding their fundamentals. This obviously helped us in 2008, when the crisis situation led to many fund houses needing to step in to plug the leaks due to real estate exposure. Even if you look at the current scenario, real estate companies are quoting at a fraction of their earlier high valuations and at the same time, real estate prices in Mumbai are at an all-time high. This discrepancy cannot continue and fundamentals need to get aligned.

We are very conscious of credit risk. When we move down from AAA to AA or A, we are very selective about the company we pick up. We also need to keep in mind that the rating changes lag the market; they are not leading indicators.

You say that one has to be opportunistic to some extent. Then why are you not opportunistic enough to launch a crop fund?
In India we are not sure if a credit opportunities fund would have a sufficient investment universe, unlike the West, where the corporate debt markets are far more mature. Most of the trading here takes place in the AAA and AA category. If one intends to buy a low graded paper and then plans to sell it when it gets upgraded, it could backfire if things don't go as planned. In a developed market one can buy a Credit Default Swap (CDS). Here there is no option. If a call goes wrong it will impact the fund. Also, in a more developed market, AAA levels are so low that one is forced to take that much more risk to generate some alpha. In India you can get a return of 7-8 per cent on highly rated paper, so it's not necessary to go down the credit ladder, especially given the depth and liquidity of the markets.

Which debt fund should retail investors consider now?
Consider funds like Templeton India Short Term Income Plan and Templeton India Income Opportunities fund, along with ultra short term funds, depending on individual requirements. Short term rates might decline over the near term, but long term interest rates are unlikely to fall on a sustainable basis (until the macro situation changes), so one should limit exposure to long term funds. My personal exposure in the fixed income space is predominantly in these funds.

PPP: Purchasing Power Parity / BoP: Balance of Payments / G-Sec: Government Securities / GDP: Gross Domestic Product /NBFC: Non-banking Financial Corporation / PSU bonds: Public Sector Unit bonds / SO: Structured Obligation / PTC: Pass Through Certificate / CD: Certificate of Deposit / CROP Fund: Credit Opportunities Fund / RBI: Reserve Bank of India / OMO: Open Market Operations / IPO: Initial Public Offering / 100bps = 1% .

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