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When risk-taking doesn't pay

In India, there is no investment case for riskier debt funds, such as credit-opportunities funds and long-term gilt funds

When risk-taking doesn

Does investing in riskier mutual funds really reward you with higher returns? If you look at the returns of different categories of equity funds in the last 5 or 10 years, your answer would be a yes. Over the last five years, mid and small-cap funds - which take higher risk- have clocked a 17 and 20 per cent CAGR respectively, while large-cap funds are at 10 per cent. The ten-year picture again shows that mid and small-cap funds have delivered a 5 percentage point higher CAGR over large-cap funds.

Risk premium in debt
It is when you turn to debt funds though, that you wonder if it is really worth taking any risk at all, in this category. Measured on a risk scale, liquid funds are the least risky category of debt funds because they minimise both interest rate risk (by investing in very short term debt) and credit risk. At the other end of the spectrum, Credit opportunities funds (which invest in lower-rated corporate bonds for higher interest) and Long-term gilt funds (which invest in long-term government bonds to benefit from falling rates), are the riskiest types of debt funds.

No big payoffs
So what is the return difference between these riskier debt categories and the safer liquid funds? Over a three year period, liquid funds have managed an 8.7 per cent CAGR, while Credit Opportunities Funds have managed a 9.7 per cent and Long-term gilt funds have returned 8.8 per cent. But then, three years may be a short period over which to evaluate returns because it may capture just one phase in the interest rate cycle.
Reckoning returns over five years, Credit Opportunities Funds have managed 9.4 per cent and Long-term gilt funds 9.5 per cent CAGR, compared to 8.8 per cent from liquid funds. That is a 56-66 basis points extra return per year, for additional risk-taking.
For ten years, the numbers are 7.9 per cent from Credit Funds and 8.4 per cent from Long-term gilt funds, compared to 7.8 per cent for liquid funds. This suggests that Credit Funds have offered just 10 basis points extra for the additional credit risk over ten years, while long-term gilt funds have managed 60 basis points.

What 'kicker'?
These differentials will no doubt change, if you make comparisons for different time frames. But the broad thrust of these numbers suggest is that the extra returns that you usually get for assuming extra risk in debt funds, is anywhere between 10 and 70 basis points (0.1 to 0.7 percentage points).
Conservative investors may well wonder whether this kind of return 'kicker' is really worth all the worry that riskier debt funds subject them to. In a rising rate environment, long-term gilt funds can subject one to NAV losses. In a difficult economy, credit opportunities funds can see sudden erosion in their NAV due to defaults or downgrades in their corporate bonds.

Why low reward?
The low reward for assuming extra risk in the context of Indian debt funds, cannot be wholly blamed on the managers of these products. Structural peculiarities of the Indian bond market are to blame too. Broadly, one can identify three reasons why riskier debt funds don't offer a much higher reward in India.

Flat yield curve
For one, there is the flattish yield 'curve'. Debt market theory tells us that investors who are willing to hold on to a bond longer should be rewarded with higher interest rates for the added risk. This usually means that long-dated bonds offer higher interest than short ones, resulting in an upward sloping yield 'curve'. But in India, there is often minimal difference between yields on short term and long-term bonds.
Just consider the yields on Indian bonds in early July, 2016. For those who lent overnight money, the call money rates on that day were 6.3 per cent. On 91-day treasury bills (Government borrowings for 91 days), yields were 6.7 per cent. Stretch that government bond to 10 years and the yield was still only 7.4 per cent.
In effect, what you get for buying a government bond for 10 years instead of one for 91 days is a 70 basis point extra yield. This clearly explains why the yield differential between liquid funds and long-term gilt funds in India, over the long-term, isn't much higher than 60-70 basis points.
For investors to really make a lot of extra returns on long-term gilt funds, they have to make extra gains from a fall in interest rates. This requires them to buy these funds at the top of the interest rate cycle and exit at the bottom, which they may not manage to do consistently.

Sticking to safety
A second reason why Indian debt markets hardly reward risk-takers is that the market is terribly under-developed. The bulk of issues, trading activity, volumes and institutional investors such as insurers and pension funds all chase only the 'safe' instruments - either g-secs or AAA rated corporate bonds. Even companies rated AA have a tough time finding investors for their bonds, leave alone those in the 'junk' grades. Both RBI and market experts have long bemoaned the fact that the bulk of the action in the Indian bond markets is restricted to g-secs or at best AAA rated bluechip companies.
With few takers for lower rated corporate bonds, investors in these bonds have to take on liquidity risk in addition to the risk of default by the borrower. This is in fact a big constraint for mutual funds running Credit Opportunities Funds, especially in the open ended format. If they go by their mandate and aggressively shop for AA or lower rated corporate bonds, the returns look good as long their issuers are fine. But the moment a company is downgraded, or even if there is a general liquidity crunch in the market, the liquidity for their holdings dries up. Such liquidity risk can eat into the higher returns that investors hope to earn from lower rated exposures.

Expense ratios
While nothing much can be done by the fund industry about the two factors mentioned above, there is something it can do about the third factor, which is the expense ratio of debt funds. Investors in India may not mind paying a higher expense ratio for small-cap and mid-cap equity funds over large-cap ones, or active funds over passive ones because in the equity category, riskier funds generate significant excess returns for extra risk they take.
But with the reward for risk-taking so low in debt funds, fund houses certainly cannot afford to demand much high costs or fees to manage riskier debt funds. But the fact of the matter is, they do.
The latest expense ratios for liquid funds, as captured by Value Research Online show that they charge anywhere from 0.02 per cent to 1 per cent a year, with most funds sticking to 0.20 to 0.30 per cent range on annual fees. But expense ratios on Credit Opportunities Funds range from 0.23 to 1.85 per cent, with most funds in the 1 per cent plus range. Long-term gilt funds have expense ratios of 0.13 to 2.1 per cent, with most funds falling in 1.4 per cent plus range.
In long-term therefore, if you as an investor earn 0.6 per cent a year by way of extra returns from riskier debt funds, the fund house also gets 0.7 per cent (in Credit funds) or 1.1 per cent (in long term funds) extra as fees for these products. We have reckoned non Direct plans as most retail investors are invested in them.
As long as India's bond markets retain their structural problems, it may be up to India's debt fund managers to lift returns for their products, by cutting back costs on their riskier debt funds. But the million-dollar question is, will they do it?

This story appeared in the September 2016 issue of Mutual Fund Insight.