In a chat with Value Research, Arvind Chari, Head-Fixed Income & Alternatives of Quantum Advisors, talks of how investors should approach debt investing
22-Mar-2019 •Aarati Krishnan
Debt fund investors tend to be more worried by credit-related risks to their NAV than interest rate-related risks. Why?
You need to step back and see the objective of investors who have invested in these funds and the communication they have received from fund houses, advisors or distributors, who sold them the product. Take the case of liquid funds. A liquid fund is perceived, positioned and marketed as a fund that takes no market risks - it invests in less than 91-day securities. It is supposed to be quickly redeemable. Individuals see it as an alternative to savings accounts or bank fixed deposits. Corporate treasuries in liquid funds seek low volatility in returns. So, most people who invest in liquid funds do so more for safety and liquidity than returns.
Yet if you see some recent instances of companies where credit risks have cropped up - Amtek Auto, Ballarpur Industries, JSPL, IL&FS - they have been held by liquid funds. That is problematic. Quantum AMC urges people not to invest in liquid funds for returns but to invest in them for safety and liquidity.
On a steady state basis, the returns of a zero private credit risk liquid fund, like say the Quantum Liquid Fund, could be about 25 to 50 basis points lower. Usually, the spreads between corporate bonds and government securities in the very short term are quite narrow because there's a very low probability of default within 1-3 months even by an AA issuer. The spreads widen only when incidents like IL&FS happen. But you need to weigh those additional returns you are trying to make against the risk of losing nearly a full year's return if there is a default. The investor needs to answer if she/he is okay with that, on its short-term cash surplus investing.
If running a liquid fund only with government securities is possible, why do the majority of liquid funds in the market take exposure to corporate paper and end up taking on default risk? Is it that the size of the funds forces them to take corporate exposure?
No, the largest issuers in the Indian bond market are the government and triple A-rated PSUs. But what has changed is that banks earlier used to issue CDs (certificates of deposit), which used to be bought quite a lot by liquid funds. But in 2012, the government clamped down on bank bulk deposits. The PSU bank slowdown has also reduced CDs being issued. When the CD issues began to shrink, liquid funds moved to commercial paper (CP) issued by corporates/NBFCs in place of CDs. Today, nearly two-thirds of an average liquid fund's portfolio is invested in CPs. A good chunk of that is to entities without a long-term AAA rating. This results in credit risks as well as liquidity risks, as a majority of these CPs are not as liquid as treasury bills. So, if the liquid fund faces sudden redemptions, it may have to borrow to meet it, which we have seen being used increasingly.
Now, if the funds had wanted, they could have parked that money in the overnight CBLO/Repo market. The reason they go to CPs instead is to earn a higher yield. So, then effectively, liquid funds have taken to investing in corporate paper mainly for returns.
SEBI has recently made it compulsory for debt funds to value all securities with over 30-day maturity on a mark-to-market (MTM) basis. What is the impact of this on liquid funds?
Right now, with this rule applying to more than 30-day securities, we have seen most fund managers saying that the returns of liquid funds will come down. Perhaps a lot of funds will now move to hold less than 30-day corporate securities. This will require the borrowers also to issue and roll over their debt more frequently. I do not understand whose purpose is being served here by not moving to full MTM. I think SEBI would like to move to a complete mark-to-market valuation over time but is trying to implement this rule gradually to avoid disrupting the market.
If liquid funds see sudden losses or gains in their corporate securities and if they don't use mark-to-market valuations, their NAVs will not reflect the true picture of their underlying portfolios. Therefore, it would be ideal to have liquid funds move entirely to mark-to-market valuations.
Does the liquidity crisis in the bond market continue?
You need to differentiate between banking system liquidity and sentiment here, which most people don't. There is no liquidity crisis. Banking system liquidity has been fairly comfortable in recent months because RBI, particularly after the new Governor, has been quite proactive about providing systemic liquidity. They have several tools to do this-open market operations (OMOs), term repos and now the forex swap. They have even provided the market with an OMO calendar.
But you need to distinguish between the availability of liquidity to banks and that to specific entities, such as NBFCs. Whether the struggling NBFCs get adequate liquidity is a function of market sentiment towards those NBFCs. Banks or mutual funds may have money but may not be comfortable about lending to certain NBFCs or corporates owing to a higher risk perception. So today, I believe that systemic liquidity is fairly comfortable. Yes, there could be short-term worries in March around government spending, advance tax and so on. But this may settle down by April.
The sentiment is also getting better at the margin for NBFCs and corporates who are transparent and have sound balance sheets, they are able to borrow at better rates today than during September-December. But for corporates or NBFCs suffering from a high-risk perception, the sentiment is still poor.
Retail investors find debt funds to be very confusing products. How should they invest in them?
The first question is whether the investor needs debt funds at all. Most retail investors have a lot of money in savings accounts, bank deposits, VPF and PPF and if that makes up a significant allocation, the investor needs to figure out if s/he needs more fixed income or equities. For investors who are not in their 50s or 60s, the allocation should probably be higher in equities and thus, they need to move away from fixed deposits/bond funds to equities. For others, debt funds/FMPs can be a surrogate to the bank FDs.
Two, because we are in this real rate inflation targeting framework, where the inflation band is 4-6 per cent, I feel the repo rate will find it very difficult to go below 6 per cent. It may do so in the short term but is unlikely to sustain there. It should also find it tough to hold above 8 per cent for a long period. Therefore, I think the new sustainable range for the repo rate will be between 6 and 8 per cent, unlike earlier where it swung between 4.5 and 9 per cent. So, volatility in interest rates should be lower, but investors still need to understand the relation between changes in market interest rates (yield), maturity of the instrument (duration) and its market price movement before investing in bond funds.
As a general thumb rule, I believe, if you see repo rates/ fixed deposits between 6-7 per cent and are rising or likely to rise, this is a better time to be in liquid funds instead of locking your money in fixed deposits. Liquid funds get repriced very quickly and they help you benefit from rising rates and avoids capital losses of bond funds. When the repo rate tops say 8 per cent, you can consider to lock into longer tenure bank FDs for say 3 or 5 years or invest in bond funds with a 3-5 year view. Bond funds from that point can make high accrual and capital gains from eventually falling rates.
Three, be careful when you invest in bond funds based on the past one year's returns. If the past return is high saying double digits, the returns in the next one year are most likely to be lower.
Fourth, if you read the monthly commentary of the Quantum Dynamic Bond Fund, they tell people upfront that this is not a product for very small or short-term investors. They tell investors that the returns can be negative in the short term and this fund is not like a fixed deposit. I would also add that investors should have a 3-year view while investing in a bond fund.
Fifth, while choosing debt funds, retail investors should prioritise Safety and Liquidity over trying to earn very high returns. Debt funds are not wealth-generating products. If invested wisely with discipline, it should help you protect your wealth and grow it slowly over time with lesser volatility.