Category Archives: Fixed Income

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>

Debate on Debt MFs

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Greetings from PenguWIN

In this blog, I would like to compare and contrast Debt Mutual Funds and other traditional Fixed Income products. In my earlier note on decoding the jargons, I had briefly explained about Debt MFs which you might want to refresh before reading further.

Like a commercial break, I would like to deviate a minute and mention about 2 of our new partners (more than 3 months old now) that we have tied up with - ICICI Prudential for Life Insurance and Bajaj Allianz for Health, 2 large and established players. You can reach out to us if you have any requirements 

The objective of this blog, is to discuss risk-return profile associated with the fixed income products including Debt MFs. With some of the recent setbacks including IL&FS (Infrastructure Leasing and Financial Services), a “AAA” rated company and more so like a PSU, started by LIC, SBI, HDFC, it is extremely important for investors to understand the risk return profile of the instruments in the debt space. The IL&FS could be a black swan event, but whether there are more skeletons in the closet is anybody’s guess. The moot point is, as a fixed income investor, do you want to take some risk for incremental and tax efficient returns or stick to secured products like postal deposits and government bonds. As far as bank deposits are concerned, since Independence no scheduled commercial bank has defaulted (SBI, public sector banks, private banks, foreign banks part of second schedule of RBI) and can be added to the list of secured products

Traditional fixed income products include bank deposits, postal deposits, company deposits, PSU bonds, government securities et al. When I refer to bank deposits, it covers the umbrella of products including savings A/c, Term deposits with various maturity periods, tax savings deposits, recurring deposits, senior citizen deposits, Government schemes administered by banks like public provident fund, senior citizen savings scheme (SCSS, different from senior citizen deposits), girl child benefit program (SSY). Fixed income schemes from Nidhis, Chits (Saradha), gold jewellers’ schemes (Balu, Devi), benefit funds (Royapettah and Alwarpet) and even some company deposits have defaulted in the past. At the same time some of them are operating well with prompt interest and principal payments to investors. A large number of NCDs (non-convertible debentures) have been issued in the past and even as recently (L&T Finance NCD which got oversubscribed) as 2 weeks. This would continue as long as investors have faith and appetite. An instrument that is rated “AA+” by a rating agency (CRISIL, CARE, ICRA, India Ratings) and pays an interest rate of say 10% per annum definitely sounds attractive as a bank will not pay more than 8% in the current scenario (ignore exceptions). Assuming that such a company defaults in repayment of interest or principal, rating agency is not going to take care of the investor interest. The IL&FS is a classic case where AAA rating moved swiftly to default and flummoxed everyone.

Now, let’s look at the case of Debt MFs. Several fund managers from some best of the fund houses had taken exposure in IL&FS and their values were marked down, resulting in their 1, 3, 6-months and 1-year fund returns turning negative. So, as an investor will you be able to withstand a situation like that is something that you need to make up your mind. This does not mean that your returns will be negative overall as typically these are funds where the investors are expected to stay put for 3 years (to get the tax advantage through indexation). The fund manager will definitely make it up and the chances of getting a negative 3-year return is almost nil. But, if you pull out in panic or you have a contingency and need the fund, then you might have to compromise on the returns. However, IL&FS has dented even a liquid fund and an ultra short-term fund, that are supposed to be safe, to a 1-year negative return.

IL&FS is not the only (but popular) case where things went wrong and in the past 2 years, there have been several cases including Amtek Auto, Jindal Steel and Power and Ballarpur Industries (may not have a recall among retail investors)

So, how do we decide on good funds with the limited information that we have? If we take the scenario of short-term debt funds like liquid, overnight, ultra-short, money market, low duration where the investment duration varies between a day and a year (defined clearly by SEBI), the chances that the returns will turn negative is relatively less (and not “nil”). Within this set of fund categories, if we focus on parameters like the size of the fund (larger the better), level of diversification, portfolio composition in terms of rating (% of AAA, AA, A1+ rated instruments), long term track record, the chances of picking a loser is less.

The advantages of the short-term debt funds are:

  • Returns in the range of 6%+ even for short periods of 1 week+, which is approx. 2% plus compared to what we get in bank/postal deposits.
  • Steady returns without penalty, irrespective of the duration unlike banks/postal deposit where the return will be less along with penalty, if pre-closed before the contracted period (like 91 days term deposit and closure in month 2 itself)
  • Tax efficient, when withdrawals are made for cash flow requirements as the withdrawn amount has a component of principal and capital gains, unlike interest component in Banks/Postal deposits.

We are not talking about capital erosion in all cases and only negative returns for a certain period time which might be made up in a short time frame (happened with several cases in the past). If I can take an example to explain: Assume that an amount of 1 lakh is invested for 3 months and the expected return from the fund is 6%.  The fund value goes up to 1,00,500 by end of month 1 and in month 2, it returns a negative 0.25% (-3% on an annualized basis), and again makes up positive 0.75% in month 3. You will end up with a positive return of approx. 1,01,004/- on your investment over 3 months.

I am attaching the profile of one of our favourite short-term funds which we have recommended for a lot of investors and I personally have significant investment in this fund, for my cash flow requirements. The fund scores high on size, returns over 10 years are fabulous, no history of even a 1-month negative return, comes from a top fund house and managed by one of the best debt fund managers in the Industry. However, the credit quality of the holding is mediocre. But given that all other parameters are great, I feel that it’s worth the risk.

All weather short term fund

However, if you still do not want to take any amount of risk, then stick to Bank and Postal Deposits, atleast till things settle down. Is there a period when things will settle down? Its anybody’s guess and its like asking the Finance Ministry, RBI, SEBI etc. to give a guarantee that another IL&FS or Saradha or Sathyam or Nirav Modi will not happen again ?

“In investing, what is comfortable is rarely profitable.” – Robert Arnott

<Blog # PenguWIN 1065 – Debate on Debt Mutual Funds>

FRDI bill: Please dont Panic!

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Warm Greetings from PenguWIN:

                            Couple of weeks back, one of our clients, who is 3 years away from retirement, reached out to me with the question of safety of bank deposits. Subsequently I got calls from atleast half a dozen clients and yesterday morning, one of our key clients, senior citizen, spooked by FRDI (Financial Resolution and Deposit Insurance Bill), called and wanted to move his major share of bank deposits to Mutual Funds (Liquid Funds). To allay the fear of investors, I thought that I can put together a write-up and will try to keep it simple.

However good the social media tools like Twitter, WhatsApp are, they have their own drawbacks. Both Twitter and WhatsApp are tools to disseminate information; problem is its mostly copied content and forwards to “N” number of people, many a time without even reading the content. A major share of the rumours that the bank deposits of investors can be used for rescuing them (Banks) in an event of financial crisis, can be credited to WhatsApp and Twitter.

The objective of the bill is to set up a new organization, Resolution Corporation that will closely monitor banks/financial institutions and help them resolve, in case of crisis situation. The controversial clause in the bill is the “Bail-In” option where the savings of depositors can be leveraged to rescue the bank. The opposition parties, including Congress have vehemently opposed the bill in the current form and unless all controversial clauses are modified/removed, it will not see the light at the end of the day. Most bank depositors are ignorant of the fact that the current system in place, where a bank gets into a financial crisis, will compensate only to the extent of One Lakh through insurance provided by Deposit Insurance and Credit Guarantee Corporation (DICGC) under RBI. For all these years no one was agitating to revise the insurance amount and why now? The depositors who knew about DICGC too never complained as they firmly believed that RBI and Government will intervene and set things right.

In India, a large portion of the bank deposits are held with public sector banks, which are owned by the Government of India. Hence, usage of depositor’s funds in the banks to resolve issues will have huge ramifications. Unlike other developed countries, our proportion of savings in banks is also high. So, in case the bill is passed in the current form (which is hypothetical) Bank runs (depositors trying to withdraw funds at the same time) will be triggered resulting in colossal impact to our economy. The reason for skepticism in this case is because the rumours are spread with the rider “The current PM is very powerful and is capable of imposing anything like Demonetization”.

About 15 years back there used to be a private bank called Global Trust Bank (GTB) which got into a crisis and RBI and Government rescued it by merging it with Oriental Bank of Commerce, without affecting the interest of the depositors. RBIs scheduled commercial banks ( PSU and Private banks – not cooperative banks) have never defaulted and depositors interests have never been compromised. So, there is absolutely no reason to fear that hard earned money of depositors will be utilized to resolve bank issues. If depositors are not convinced and still sceptical, then there are multiple threats to worry about like a world war getting triggered because of nuclear weapons usage of North Korea or India losing its patience against Pakistan’s support for terrorism and decides to go for a full-fledged military solution (war). I don’t think we are obsessed and worried about wars breaking out and same should be the temperament in the case of FRDI and “Bail-in”

 

<Blog # PenguWIN 1056 – FRDI bill: Please dont Panic!>

Category: Fixed Income, General