Category Archives: Mutual Funds

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

Stay the course, Equities will deliver

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Greetings from PenguWIN:

PenguWIN wishes you a wonderful Vinayagar Chaturthi !!!

Greetings

There is a sense of negativity in the market with investors doubting whether Indian Equities as an asset class has lost its mojo. Returns from lumpsum investments done 3 years ago, SIPs that are 4 to 5 years old are close to zero or even negative.

Will Indian Equities Deliver? The answer is a resounding “Yes”, Stay the course and Equities will deliver. As long as businesses thrive and make profits (Automobile sector woes are a passing phenomenon), you can be rest assured that equity investments will be able to deliver higher returns than any other asset class as picturised below.

Instead of being verbose I have attached charts based on actual data that will help increase your confidence level and conviction in equity. I have picked funds that have a minimum of 10 years history and not the best performers (to make the charts look better)

Highlights

  • 10 Jan 2008 was the all-time high reached by Sensex – 21206. Investment done at this point as Lumpsum is depicted. On 27 Oct 2008 Sensex reached a low of 7697. i.e. 64% down from high on 10 Jan 2008
  • Lumpsum investment of 1 Lakh on 4 Jul 2014 and 10,000/- SIP per month starting Jul 2014
  • Advancing the SIP start date (10K per month) from Jan 2013 instead of Jul 2014.

“When there’s nothing clever to do, it’s a mistake to try to be clever.” Howard Mark

<Blog # PenguWIN 1070 – Stay the course, Equities will deliver>