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Over-complicating Fixed Income

With all their talk of duration, credit and accruals, debt funds seem to be designed to thoroughly confuse the retail investor

Today, the mutual fund industry prides itself on selling the most transparent and investor-friendly products within the financial services industry. Mutual fund houses like to pat themselves on the back for marketing products that are easy to understand, benchmarked against publicly available indices, rated by third-party agencies and moreover have well-defined mandates and portfolios that investors can assess for themselves. But while all this may apply to equity funds, debt funds are a different animal altogether.

What's your call?
First let's talk about simplicity, which is completely missing with the debt fund category. In the equity category, MFs have a simple proposition to offer to investors. Buy a diversified equity fund with a good track record and hold it tight until you need the money.

But ask a fund house about its debt schemes and you are likely to soon have your head spinning. If you would like to take a 'duration call' with low 'credit risk', you can buy medium to long term gilt funds. If you would like an 'accrual strategy', you must buy corporate bond funds. If you would like a mix of 'duration calls' and 'credit calls', income funds will suit you.

To most lay investors, this is Greek and Latin. If a retail investor knew when to take a 'duration call' and when to take a 'credit call' he would scarcely hire a fund manager to buy bonds on his behalf.

Or horizon?
Fund houses try to 'simplify' this by asking investors to choose their debt funds based on their investment horizon. If you are a 'long term' investor, buy medium to long term gilt funds; if you have a short horizon of a year, stick with short term income funds. If you are looking for a 3 month product, go for liquid funds.

But the truth is that as a fixed income investor unlike an equity investor), I may not have a specific horizon in mind at all. All I may have is a return target (say, 2 per cent more than a bank FD) and a risk appetite (I don't want losses on my debt fund, under any circumstance!)

Too dynamic
But the truth is that there no plain vanilla debt fund, akin to the diversified equity fund, which can fit such an investor. Ha! But we have dynamic bond funds and income funds - the fund industry may retort. Well, both dynamic bond funds and income funds again, are far too 'dynamic' for retail investors.

Within the dynamic category, we have funds which take 'duration calls' dynamically, those which take 'credit calls' dynamically and those which take both dynamically. So which would you choose?

Not comparable
As to income funds, the portfolios in the category are so varied that you cannot even compare one income fund to another! A recent analysis revealed that Value Research's Income Fund category for instance, featured over 90 funds with myriad sub-plans (institutional, regular, retail, super-institutional). Now, the average portfolio maturity of these 90 funds varied from 1 month to 18 years (as of May 2015). Their annual expense ratios varied from 10 basis points to 258 basis points.

And while some of these funds were entirely into g-secs, others were mainly into AA and lower rated corporate bonds.

This variability in portfolio maturity and credit risk ensure that it is extremely dicey to either compare income funds based purely on returns, or buy them based on their recent performance. A fund which has an 18 year maturity can deliver a double-digit return when interest rates fall; but if rates spike it can expose you to nasty losses. Another with a 1-month maturity may struggle to get to a 8 per cent return, but may remain rock solid if rates spike.

This variability in the strategies of income funds makes it quite difficult for any independent agency to compare across the category and for investors to buy a fund based on its performance relative to peers.

Secret benchmarks
If comparing income funds to each other is a tough task, benchmarking them is not easy either. Unlike the equity category where the common benchmarks - the Sensex, Nifty, CNX 500 and various mid and small-cap indices- are publicly available and used by most funds, debt funds use proprietory benchmarks which are not easily available in the public domain.

Some debt funds are benchmarked to the NSE bond indices, some to the CRISIL indices and some to the I-sec indices. None of these are available to the retail investor. Nor is the composition of these indices available publicly for investors to understand why a fund is outperforming or lagging these indices.

Nor are debt funds uniformly low-cost, as one would assume. In recent times, the expense ratios of the top performing funds, especially of the longer-duration and corporate bond variety have crept up to the 1.5-2 per cent mark. Such expense ratios may be acceptable in equity schemes which can outperform the market by 500 basis points or even more over the long run. But what justifies such high fees in a debt fund?

Overall, the entire structure and operation of debt mutual funds today, suggests that the category is still stuck in the corporate-treasury mind-set. Corporate treasuries may be able to specify a precise time horizon for parking their money in debt funds. They may also know when to take duration calls and when to go out on a limb on credit. They may also be astute enough to go direct with their debt funds, skip distributors and pay lower fees.

But if the fund industry is keen to position debt funds as a retail product, as many CEOs say it is, it needs to rethink this category from scratch. What we need is plain vanilla debt funds that make some sense to the retail investor.

A debt fund that can give diversified equity funds a run for its money is one that invests across the fixed income spectrum (wholesale deposits, CPs, NCDs, g-secs, whatever), is benchmarked to a bank FD (it should return at least 100 bps more) and has a reasonable (say less than 50 bps) expense ratio. When will we have the NFO?