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Debt Mutual Funds Simplified

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Greetings from PenguWIN,

I wanted to pen a short and simple write-up on Debt funds. The objective is that the investors should have a basic understanding of what a debt fund is and how it works. 

Debt funds are categorized based on the maturity profile of the instruments/securities/papers (used interchangeably) that they hold. In simple terms you can think of 60 days FD (Fixed Deposit), 91 days FD, 1-year FD and so on. If money is required in about 3 months, it is invested in a 91 days FD and if it is required in 13 months, it is invested in 1 Year FD. Similarly, depending on the tenure, investments in debt funds start from Overnight funds (few days), Liquid funds (weeks to a few months), Ultra-Short Duration funds (more than 3 months), going up to Long term, and Gilt funds. 

 

Debt funds comprise of instruments of multiple attributes – interest rate, company, rating, and tenure. Instruments over 1 year are long-term and rated as “AAA”, “AA+”, “AA” and so on. Instruments less than a year are rated as “A1+”, “A1” and so on (Crisil’s Rating Scale). Government issues long-term securities, referred to as GSECS and short-term securities, less than a year maturity, referred to as Treasury bills. GSECS and T-bills are also instruments (sovereign and backed by Government of India) that debt mutual funds invest in. 

 

The difference between a Bank FD and a Debt fund is that FDs are linear products (no volatility). But, if an investment is made in a 1-year FD for 6% and broken in 6 months, the interest rate will probably be around 4%, which is the rate for 6 months and there could be an additional penalty too. However, if an investment is made in a short-term debt fund, say Ultra-Short-term fund for 1 year which is expected to provide a return of 6%, typically, it will stabilize in a month (even less in many cases) and even if an investor exits in say, 2 months, the return will be about 6% (on an annualized basis). The returns will not be linear but close to linear (say, 5.5% in week 1, 6.2% in week 2, 5.8% in week 3, and so on) which provides a huge advantage of investing short-term money that might be required anytime. If an investor remains invested for 3 years, tax benefits through indexation kick in, which is very significant, and FDs do not get this benefit. Debt Funds do not have tax deduction at source (TDS) which means there will not be annual taxes to be paid. It needs to be paid only when the fund is redeemed. FDs have TDS which means compounding effect will be reduced.

 

Unlike FDs, fund managers trade securities in their schemes, purchase when money comes into the fund (investments), and sell (redeem) when money is required by investors. The volatility of returns from Debt funds is considerably low but not “Zero‘ and that’s why debt fund returns are close to linear but not perfectly linear. So, debt funds NAV (Total value of fund/ Number of outstanding units) increases slowly. Only during extreme situations, there would be wide swings in the NAV as a result of changes in the ^yields of underlying instruments. 

 

Typically, if a scheme/fund has invested in a proportionately high number of “AAA” papers, “A1+”, GSECs, the risk level is lower and so will be the returns (AAA yield will be lesser than AA, AA less than A+ and so on). To increase the fund returns, fund managers invest in less than AAA, say “AA-“ type of instruments. If a fund has 50 instruments, 10 maybe AAA, 15 in A1+ and rest in AA and AA-. Also, securities that are AA need not be of low quality. Ex. Airtel’s 8.25% Non-Convertible Debentures (NCD) is rated “AA” and knowing the pedigree of the company why would anyone hesitate to invest? If the question is, then why is it not rated “AAA”, it is beyond the scope of this write-up and requires an explanation of the credit rating process.

Daily, depending on the transactions done, the instrument gets a value like AAA, 3 years is 6.75, 5 years is 7.2, and so on. The price of the security goes up and down as it gets traded, based on demand and supply. Since the interest rate is constant like 8.25% in the case of Airtel NCD, it’s the yield that varies periodically.

 

^Yield is the return that you would get for the current price of the security. If Airtel 8.25% NCD has a lot of demand, then the price of 1 unit of the bond, say 1000 Rs. will increase to 1100 but the interest rate remains the same 8.25%. In this case, the yield would be 8.25% of 1100 or 7.5% i.e. Yield decreases as price increases and increases as price decreases (inversely proportional). Yield is the reference and key parameter for a security/instrument like the current market price of a share (Reliance Industries stock price is Rs. 1400/- (current trading price) and the face value of Rs. 10/- loses its significance.

 

When there is liquidity squeeze in the market i.e. demand for instruments by buyers goes down than supply or sellers trying to sell too many instruments, the price of the instrument/bond goes down and the yield shoots up. In such a scenario when a fund manager tries to sell lesser quality papers (AA, A+) the takers will be lesser resulting in a distress sale. If the value of a bond (Rs. 1000 face value) goes down to say 800, then the Net Asset Value (NAV) goes down sharply and this is what happened to the 6 Franklin Debt Funds which were in the news, recently. There could be a situation where there are no takers at all and price discovery itself becomes a challenge. If a distress sale happens then there will be a huge erosion of NAV, severely affecting the interests of investors. The underlying instruments (say even “AA”) can still be good and companies might pay back the loan in time. The current crisis is more of a demand-supply mismatch rather than the credit quality of the instruments. All other factors remaining the same, the quality of papers like AAA Vs AA might matter. But, Franklin has been managing the funds in this fashion for over a decade without any issues, investing in lower credit quality instruments, and providing substantial additional returns to its investors. 

 

Leave no stone unturned to help your clients realize maximum profits from their investment - Arthur C. Nielsen

<Blog # PenguWIN 1076 – Debt Mutual Funds Simplified>

Covid-19 Shakeup

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Greetings from PenguWIN,

The continuous fall in the equity markets has spooked almost every investor. While 2008 was a major crash in value terms, the Corona Virus impact has caused one of the fastest crashes that the stock markets have witnessed – i.e. about 33% down in less than 2 months (Sensex reached 42,273 on 20th Jan 2020) and 31.3% down from 20th Feb which is less than a month.

The question that everyone has in their mind and some people have asked me is when will we reach a bottom and turnaround. While no one can give a correct answer, which is how the stock market works, I wanted to share my opinion as an investor in the Indian Equity market for over 18 years now.

Whenever markets have gone down it has always come back strongly and breached the previous high. It’s a question of time and that could happen in a matter of few weeks or months.

The big impact to markets in the past were factors including scams, dotcom, financial crisis and the impact of SARS, Swine Flu, Ebola which are considered more dangerous than Covid 19 was negligible. However, with the power of social media, today, the spread of news and events is extremely high and gets exaggerated. The moment the Virus gets controlled like what we hear about China, markets will turnaround extremely fast. So, please do not keep looking at market information which is the best thing to do in situations like this

The number and volume of investments in Indian Equity markets by Indian investors has become significantly high including provident fund investments, insurance companies and the steady flow of SIPs which was not the case earlier, where retail investors were very limited.

The one-year FD rate offered by SBI is 5.9%. Assuming the investor has an income of 10L plus the post-tax return will work out to about 3.9%. Equities on a long term will definitely be able to provide about 11-12% and post-tax return would be about 10%. Even if we assume that the post-tax return is only 9%, the differential return will definitely be 5%+ and hence equity markets that shakes us like this, at times, cannot be ignored.

While no one can deny the fact that the experience we are undergoing is unpleasant, without pain there is no gain. Please remember that we are in a situation today were bank depositors are put in moratorium (limits on operating the account) and other than sovereign instruments (Small savings, Provident fund), nothing is absolutely safe.

<Blog # PenguWIN 1075 – Covid-19 Shakeup>

Category: Mutual Funds

Markets on Fire Sale

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Greetings from PenguWIN

A fire sale is a sale of assets at heavily discounted prices. Here, I am referring to the sale of stocks in the market as though all businesses are closing down. Initial reports from the World Health Organization said that the death rate is between 3 to 4%, the rate being higher for 60+. Older people and those with respiratory problems, heart disease or diabetes are at greater risk. There are other sources from websites to news channels quoting death rates as low as 1%. Immunity among healthy young people seems to be high.

The impact of this Corona Virus pandemic seems to be accentuated by today’s social media like never before, with people overreacting by buying too much retail household stuff, thereby creating shortage and panic.

I am sure many of you who have invested in equity funds would be going through anxiety. However, this is a black swan event that no one can predict. We have had such events in the past including the Dotcom bubble, Ketan Parekh scam, 2008 financial crisis and every time the market has bounced back sharply and reached greater heights. These events have occurred in the past and will continue to occur in the future too. It’s just that we will not be able to predict when and the magnitude of it.

My request to you is that you stay away from monitoring the portfolio during tough times like these. The dip in your portfolios is ephemeral and will not affect your long-term goals unless you have invested money required in the near term in Equity Funds. Another blunder that people commit is to panic and sell their funds. If you have the conviction, this is the best time to be greedy and invest more (rather than sell and incur a loss). Personally, I have done this in the past and doing it now too. This does not work for all investors, especially people who have never faced a crash like this.

If you have any specific questions on your portfolio, please write to me or call me and I will be glad to assist. Both humanity and markets have withstood a lot of calamities and have seen that problems are temporary and progress is permanent

<Blog # PenguWIN 1074 – Markets on Fire Sale>