Betting on Dynamism

Rajiv Anand MD & CEO Axis Mutual Fund talks about the array of mutual funds that fixed income investors can look at and is of the firm view that dynamic funds could be the best option going forward in today's environment

You recently launched a new fund - Axis Constant Maturity 10 Year. Can you tell us the mandate of that fund?
Investors should think of this as a 10-year index fund of G-Secs. The mandate of the fund manager is to maintain an average maturity of 10 years at all points of time. This fund gives investors an opportunity to be able to execute a view on the fixed income market. It is a what-you-see is what-you-get kind of fund. Irrespective of the fund manager’s view, it will always run at 10-year maturity.
What tends to happen is that an investor may feel interest rates will fall but the fund manager need not share the identical view. That will result in a mis-alignment in terms of portfolios. So here is a fund where investors with a view on the fixed income market can execute that view.

So this fund essentially targets the institutional investor.
This fund effectively converts a retail investor into an institutional one. Basically the fixed income market is an institutional one where the minimum lot that can be traded is in crores. This fund allows a retail investor to participate in the G-Sec market. The end user can be found in the institutional space but also within the retail space and by that I include private banking and PMS space.
This fund targets investors who understand the dynamics of a debt instrument - institutional or retail. One who understands the fixed income market and looking for a cheap and convenient way to execute his view.

So basically this just adds to the entire array of fixed income funds which makes it all the more confusing for an investor.
It’s not that complicated even though there are numerous funds in this space which causes a fair amount of confusion amongst investors. Go back to basics.
If you have money to invest up to a week, deploy it in a liquid fund. Such a fund is just a substitute for a savings bank account. The returns are determined by the money market so will fluctuate. A few months ago the annual return was 6-7 per cent. Today it is around 9 per cent. It is the best option available for investors who have to park their money for a few days - it is very cost effective with no entry or exit loads. Transacting is easy, it can even be done over the phone and money is directly channelized from the bank account to the fund and vice versa.
The regulations have changed to make such funds even more risk-proof, so to speak. Fund managers cannot buy instruments with maturity of more than 90 days in such a fund. It’s a fantastic product for loose cash.
For spare cash between a week to three months, then the ultra short term bond fund is a good option. The level of risk, with regards to interest rates, is just a slight notch above that of a liquid fund.
If you have spare money for a year, then a short-term bond fund would be the answer. Here the risk on the portfolio is slightly higher than the other two options.

Do these differences really matter? A week to a month?
For sure. These buckets are important because of the level of interest rate risk and volatility in these portfolios. A liquid fund is built to deliver positive returns on a daily basis. Similarly other portfolios are constructed for the other funds.

As you go longer, it gets more confusing. The clarity is mainly there on the short-term side of the market.
As you go longer, beyond one year, there are income funds, gilt funds and dynamic bond funds.
The interest rate environment is digital - the rates are either going up or down. When going up, the funds at the shorter end of the income fund category do well. When interest rates are going down, the funds that take a longer view do well. The categorisation of the medium term gets to be a bit opaque.

So you basically advise investors to invest based on their holding period? Not on interest rates.
Yes. Their attention must be focussed on their investment horizon. You are not investing in fixed income to maximise your returns. You are investing to get a reasonable return. You are investing to optimise the return on your overall portfolio.
Equity is the best place to look at for capital gains, it is one asset class that beats inflation.
In fixed income, to maximise gains you should be able to play the interest rate cycle. This is not easy. Even the experts cannot get it right all the time.
So a fixed income investor actually addresses the issue of how to optimise his returns for specific holding periods.

You have a dynamic bond fund - Axis Dynamic Bond. Where does that fit it?
To give you a better perspective, let me compare this fund with Axis Constant Maturity Fund. The latter is for the investor who has an interest rate view. He will consider which point to enter the fund and decide which part of the interest rate cycle he wishes to ride and will keep an exit point in mind depending on where yields are. In the case of a dynamic bond fund, the investor will have a time frame of at least one year and want the fund manager to take care of volatility because he is not sure of a view on the interest rate. So when the fund manager has a view that interest rates are falling, he may position the portfolio with long term securities like gilts and when he thinks rates are rising, the fund may resemble a liquid fund. The fund manager constantly makes those duration calls. He may buy government securities or when he thinks that the spread is large, he may buy corporate bonds in anticipation that he is getting a higher coupon or because he believes the spreads between corporate bonds and government securities will narrow. So be it a credit call, an interest rate call or liquidity call, he has that flexibility in a dynamic bond fund.
So at any given point of time, the Axis Dynamic Bond Fund’s portfolio will have our best fixed income investment ideas. So if we believe that interest rates are going to fall over the next three years, then it will be of long maturity and resemble a gilt fund. But if we think that interest rates are going to fall in the next three months, then it will look like a short-term fund. So this fund will then attempt to protect the investor from a rising interest rate environment.

You have articulated your short-term funds and the 10-year fund. In the debt category, you still do not have a regular bond fund, but if you did, would it not clash with the dynamic bond fund?
I agree that an income fund would be similar to a dynamic bond fund. In an income fund, around 30-40 per cent could be in gilts, a particular percentage in corporate bonds etc. The basic structure is known. A dynamic fund is more open. So even if everyone is long, the fund manager in a dynamic bond fund can be potentially short due to his view. If he has a diametrically opposite view to the market, he can execute it in his dynamic fund, not necessarily through the income fund.

What kind of credit risk do you take on your portfolio?
None. It is always AAA or P1+.

How do you see interest rates moving right now?
There are two drivers to interest rates now. One is inflation, the other is growth. We believe that inflation has peaked and will fall till June. We are also seeing a fair amount of weakness where growth is concerned. We are finishing this fiscal year with GDP growth of 7 per cent. And into 2012-13, the growth numbers would probably be sub-7 per cent. The RBI has clearly articulated that the battle has been trying to contain inflation that is why we have seen 13 rate hikes over the past two years. It’s fair to say that to a certain degree that the battle has been won. So now the battle has shifted focus to rekindling growth - which means that the policy interest rate cycle has peaked. So now the RBI will pump liquidity in the system, which is what it will achieve with the CRR cut. And we also expect policy rates to be cut starting from April 2012. We anticipate over the next 18 months, as we saw in 2000-03, a cut of 100 bps in policy rates.

Your advice to investors?
So, given the above context of the direction of interest rates, we believe it makes sense for an investor to take some interest rate risk on his portfolio right now. So if you are a risk averse investor, then maybe you could move from a liquid fund to a short-term fund. For other investors, I would suggest a dynamic bond fund.
As interest rates come down, the portfolio will benefit from two income streams. The first is accrual on the portfolio. The second is capital gains because of the inverse relationship between interest rates and bond prices. As rates fall, bond prices will rise. This would effectively mean that NAVs are going up. So investors who have money in liquid funds or FMPs should move it to short-term or income funds.

When you talk of the fall in interest rates, do you see a consistent downturn or a volatile one?
One must realise that as one goes into longer term assets, the day-to-day volatility of the portfolios will increase. It could be for various reasons. It could be the market feeling the repercussions of what is happening in Europe or Greece, it could be the expectation of increase or decrease in size of the government borrowing programme, it could also be the inflation numbers. Growth numbers too will play an important role. There are other macro-economic parameters too that will play an important role; the current account deficit, the fiscal deficit, rupee appreciation or depreciation. We are anticipating a fall in inflation, but who knows? What if the price of crude shoots to $150/barrel? It would impact the rupee side and India’s current account deficit.
All these factors at various points of time will impact interest rates. So investors must expect volatility, something they will not find in a fixed deposit. But as long as they are compensated for this with a higher, tax efficient return, income funds are a good fit in a portfolio.

Given all the above factors, you still feel that investors should increase duration?
Despite all these considerations, we are taking a call that fixed income investors must increase duration in their portfolios. And in a volatile interest rate environment, where the movements have been quite sharp and quick, dynamic funds have the mandate to capture the moves.

G-Sec: Government Securities / PMS: Portfolio Management Scheme / GDP: Gross Domestic Product / CRR: Cash Reserve Ratio / bps: basis points, 100bps = 1% / NAV: Net Asset Value / FMP: Fixed Maturity Plan