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'Most investors should start debt allocation with short-duration funds'

R Sivakumar, Head - Fixed Income, Axis Mutual Fund, speaks about the credit environment, role of target-maturity funds and versatility of short-duration funds

'Most investors should start debt allocation with short-duration funds'

Several AMCs have been launching target-maturity funds. Even Axis has filed a few with the regulator. What are your views on them? Most such funds are being launched in the five-to-seven-year segment, with indicative yields of about 6-6.5 per cent. But if you look from a historical perspective, G-secs, SDLs have seen higher yields. So, are the yields currently on offer good enough to lock for over a five-to-seven-year period?

These target-maturity funds are slightly comparable to the fixed maturity plans (FMPs) that we used to have before (with a similar tenure). But there are a few very critical differences. For instance, for target-maturity funds, the index constituents are known upfront because there is a published index and since they are ETFs, they offer higher liquidity than FMPs. From an investor perspective, these funds essentially work similar to a closed-end income fund (with a similar tenure) and therefore provide a high degree of certainty in terms of expected returns. I would say a high degree of certainty, as returns in debt funds are not guaranteed, but if the assets purchased are held to maturity, one can expect returns similar to those of closed-end funds from target-maturity funds.

If you look at the prevailing interest rates, especially for short-term debt instruments, they have been at historic low levels over the last year in view of the COVID-19 pandemic. The RBI has substantially increased liquidity and cut interest rates, which led to a sharp fall in short-term interest rates visible in yields in money-market instruments, fixed deposits and other such fixed-income options. However, if you go slightly longer on the yield curve, let's say beyond the five-year segment, the yields are attractive relative to the current short-term interest rates. So, I think that's one reason why we see interest from both investors and asset managers to participate in that segment.

Now if the RBI starts hiking interest rates in the future, you may see yields from these assets beginning to rise. But the advantage of the roll-down strategy is that the maturity comes down as you go closer to the maturity date and therefore, the residual duration at the time of the target date becomes essentially zero. Consequently, there is no duration risk at the time of exit. So, for investors who stay invested for the entire period, the interest-rate risk is minimised. Thus, even in a rising-rate environment, these target-maturity funds essentially allow an investor to minimise the risk of mark-to-market volatility during the target period of the fund.

With yields likely to see an upward bias, 2021 looks like a complex environment for debt investors. What do you think about the short-term categories like short-duration, corporate-bond, and banking and PSU funds? Do they continue to be the mainstay for debt investors?

Rising interest rates are beneficial for short-duration debt instruments because of the big impact that reinvestment has on returns. For example, if you have a one-year bond and your investment horizon is three years or longer, assuming a rising interest-rate scenario, at the end of one year, the maturity proceeds of your bond can get reinvested at substantially higher yields than where you currently are. So typically, in a rising interest-rate scenario, you would want to be in shorter-duration instruments in your portfolio so that you can reduce your mark-to-market losses. You need to be aware of the trade-off between duration and reinvestment opportunity, with shorter-term debt instruments offering a lower duration, thereby lowering mark-to-market volatility and increasing reinvestment opportunity. On the other hand, with longer-duration instruments, it is the other way around. Upfront, it may appear that the yield on the two- or three-year bond would be higher than the one-year bond, but over a three-year or longer period, in our view, we would like to be at the shorter end right now and reinvest rather than play for slightly higher yields at this point of time and run a higher-duration strategy in a rising-rate scenario.

So, amongst short-duration funds, it's important to identify active managers who are willing to take such calls and reduce the duration in a rising-rate scenario and gradually lengthen duration when rates have finally peaked. Investors can thus benefit from such funds. Currently, at Axis, what we want to do is run relatively low durations at this point of time.

We observe that in any five-six-year holding period, short-duration funds have mostly delivered reasonably better returns than the 6-6.5 per cent that some of target-maturity funds are yielding over this horizon. Can short-duration funds be reasonably expected to deliver the same or even better returns from here on?

Absolutely, I think short-duration portfolios should be the core of any debt-investment portfolio, as they have relatively low risk and low volatility. And historically, I think the industry has witnessed that this category has had fairly resilient performance over an interest-rate cycle.

Having said that, target-maturity funds are targeting a very different need. They are meant for investors who want a roll-down maturity strategy over a particular horizon. For investors in a target-maturity fund, as you reach the target date, the duration essentially comes very close to zero, whereas in a short-duration or any other product, there would continue to be some amount of duration risk at that point of time. So, I would not call them strictly comparable. But yes, I think for most investors, I would say that start your debt allocation with the short-duration portfolio.

What are your views on the current credit environment? For a slightly more aggressive investor who would like to pursue a risky, high-yielding strategy, is the environment conducive?

I think it's important to keep in mind a few things. Firstly, the last few years, especially 2018-2020, have been difficult for the credit environment and hence, it is easy to think that this will continue in the future. But if you look at the period starting IL&FS (in late 2018), we have seen a confluence of factors, including growth slowdown, a tight monetary policy back in 2018 because of a weak rupee, rising oil prices and a rising interest-rate environment. So, the whole environment at that time versus now is very different. Currently, we are in a period of easy liquidity, low interest rates and macro-environment factors, such as growth, seem to be picking up rather than slowing down. Hence, from that perspective, as the economic factors change and you move to a stronger growth cycle, we should expect the non-AAA segment to outperform. This has started becoming evident over the last couple of quarters, as the spreads on AA bonds have start compressing relative to AAA.

Now, when the pandemic started, there were a lot of worries that there would be a significant impact on the business sector and therefore, there could be a significant number of downgrades, defaults, etc. However, this has not panned out and what you actually see is very sharp, strong resilience from corporate results. The performance of companies has been significantly ahead of what expectations were. This has been driven by the support from the government and the RBI by means of several policies. The credit sector has had significant support from policies.

Also, the impact of the pandemic has not been symmetric across all types of companies. We've seen the larger businesses outperform smaller business substantially, as these businesses are typically the ones which are rated AAA, AA, etc., and had access to the corporate-bond market, which is where we are invested in. As a result, what you see is that AA rated corporates, which are just one notch away from AAA, have actually started to outperform significantly over the last few months, both in terms of their reported results and the bond market. And I think that will continue. As long as the macro environment continues to improve, you should see further outperformance of the credits relative to AAA.

However, also remember that this is not a carte blanche to go anywhere in credits. Our view is that it makes sense for us to at least start shifting a part of our portfolio from pure AAA strategies to perhaps AA. But at this point of time, we are being selective about what AAs and perhaps a few A rated names that we are looking to buy. And as long as we are running diversified portfolios and be mindful of the fact that we are not going very aggressively down the credit curve, I think it makes sense for investors.