"Investor is acting as a portfolio manager in some sense, when investing in passive funds"

After over four years, debt funds are being noticed for good reasons. Though elevated inflation is still a concern in the context of real (inflation-adjusted) returns, rising interest rates have bumped up debt-fund portfolio's yield-to-maturity. Thereby, making their investment case stronger. In this interview, Amit Tripathi, CIO - Fixed Income, Nippon India Mutual Fund, shares his view on the current debt market, target-maturity funds and more.

Interest rates have been on a strong upward trajectory. However, many people believe that much of the future rate hikes are already priced in by the market. What is your view? Do you still expect a big upside in yields from here?
The debt markets have been reacting to both potential rate hikes as well as tightening liquidity conditions. While the former is mostly discounted, the latter is work in progress. We expect the G-Sec and OIS markets, which are more driven by pure rate considerations to be better placed, as tighter liquidity conditions along with changes in incremental demand supply going forward may put some incremental pressure on corporate debt spreads in general, over G-Secs.

The risk to our view of market having discounted both rate hikes to a very large extent, and tight liquidity conditions to a reasonable extent, is the continued volatility in global markets which is driven by varied and aggressive central bank action. The other source of potential volatility stems from the sharp moves across global currencies and our higher current account deficit numbers.

While much of terminal rate of 6.5 per cent - 6.75 per cent is already priced in, these tail risks can never be fully discounted. As such, while yields are getting more and more attractive, and we have started increasing the duration profile across portfolios, we are not at our peak duration allocations. We intend to reach there over the next three-four months as we get more clarity on global developments.

2021 has been a complete washout as far as debt-fund returns are concerned. With the rise in yields, the portfolio YTMs of categories are nudging higher. What is the current investment case for liquid & ultra-short duration funds vis-à-vis saving bank accounts?
There is always a strong investment thesis for liquid and ultra-short funds vs savings account, simply because the former pass on the real time market yields to investors with low intermediation/management costs. Whether in 2021 or now, the gross yields of liquid and ultra schemes (which are now in a range of above 6.25 per cent for liquid and above 7 per cent for ultra) always present a more attractive option as compared to savings deposits, for the right time horizon. Even while we look at it in a post facto context, it's important to compare past returns of both categories (debt funds returns and savings rates) for the same time period. Invariably the returns of debt funds over the right investment horizon are always more efficient.

With the new guidelines issued by SEBI on passive debt passive funds, there is a stronger recognition for such funds. What is your view on target-maturity funds? We see that few AMCs have filed or launched very long-dated target-maturity funds. What is the utility of these funds? Further, isn't PPF a better alternative here?
Passive funds have evolved as a viable product category for those investors who want to follow/mimic defined debt indices. Since the indices are well-publicised, investors are well aware of both the interest rate as well as the credit risk that these products entail.

Target maturity is one such category of passive debt funds, which invest into debt instruments maturing in and around a particular date (the target maturity date), in line with the underlying index which they follow. As such these portfolios have a defined life akin to FMP schemes. These funds are suitable for investors who want to invest specifically for a specified time, and who would want the residual interest rate risk to be minimal as the portfolio approaches maturity. In that sense, these portfolios can give a better sense of potential returns (in some range), since the YTMs and expense structures of these portfolios are well-publicised, and these portfolios always continue to mimic the underlying defined index which has a finite defined life.

On the other hand, like with any index / passive fund, the investor gets married to some range of potential returns basis his time of entry and choice of portfolio/index, assuming he/she holds this investment till maturity. The ability of a portfolio manager / AMC to add value by managing the interest rate or credit risk in these portfolios is minimal since they always follow the defined index tightly.

Hence the investor, when they invest in any passive fund (target maturity included), is acting as a portfolio manager in some sense since they have already taken an active decision on the potential risk and return. The portfolio manager / AMC is executing that decision in the best manner possible. This is unlike an open-end debt fund, where the portfolio manager manages the risks on behalf of the investor, within the defined regulatory boundaries of individual schemes.

Lastly, there is a strong case for investor allocation in long-term debt funds, target maturity or otherwise. That's because one large risk that investors tend to ignore is the reinvestment risks arising from investing too short vis a vis their actual investment time horizon. It's very normal that the investible surpluses for any working-age investor increase with time. As such he/she is better placed to invest in longer maturity debt funds as part of his/her core debt allocation both to reduce reinvestment risks over time, as well as to make it more tax efficient.

Most of these long-duration funds predominantly invest in sovereign or near sovereign assets which carry minimal credit risks. At the same time, they offer attractive carry (7.50 per cent to 8 per cent annualised YTM in most cases) in the current market environment. PPF is a good option but comes with amount restrictions. As such both these products need to find a place in investor portfolios depending on their investible surpluses.