I believe debt funds can play an important role in an investment portfolio. I just don’t know what and how. That’s where I reached out to Akhil Mittal, Senior Fund Manager – Fixed Income with Tata Mutual Fund. He is the expert and he was kind enough to share his views and help me learn more about debt funds.
Just to let you know, Akhil manages the following debt fund schemes at Tata MF.
- Tata Dynamic Bond Fund
- Tata Short Term Bond Fund
- Tata Income Fund
- Tata Income plus Fund
- Tata Gilt Securities Fund
- Tata Gilt Short Maturity Fund
- Tata Gilt Mod Term Fund
- Tata Floater Fund
He also manages debt portion of some hybrid funds (Tata Balanced Fund, Tata Young Citizens Fund, Tata Regular Savings Equity Fund, Tata Retirement Saving Fund – Moderate & Conservative Options, Tata MIP Plus Fund, Tata Young Citizens Fund and a few FMP’s for Tata Mutual Fund.
Here we go.
VK: Hi Akhil, this is going to be unlike any other conversation that you might have had before.
You are a debt fund manager, the specialist. I come to you as a layman to understand debt funds and how can I use them best. I have questions, which I want to ask you and get clarity about investing in debt funds. Can I?
AM: Sure, please go ahead.
VK: OK. Here’s the first and the obvious one. What role can a debt fund play in my portfolio, any investor’s portfolio?
AM: Debt as an asset class provides stability to any portfolio. The key feature of debt is that it can provide regular earnings with lower volatility as compared to other asset classes.
One can also target to meet future goals with a fair amount of certainty by investing in debt funds. Having said this, debt is also volatile and the risk varies with Duration and Credit quality of the portfolio.
VK: There are so many debt funds out there – liquid, ultra short, short, income, gilt, credit opportunities, floating rate, strategic bond, super savers, etc. And the confusion is equally much. Is there any real difference between them?
AM: Typically, there are few broad categories of debt funds.
There is the liquid and ultra short-term category, wherein the interest rate risk is less.
Then there is short-term category, where the interest rate risk is slightly more.
Then there are long-term funds like Income / Dynamic / Strategic Bond / Gilt funds. Here the interest rate risk is more than other categories.
The interest rate risk is measured by the duration of the portfolio. Higher the duration, higher is the alpha (extra return) endeavour.
Other category is credit oriented or high accrual category. Here the objective is to generate higher accrual by investing in corporate debt papers (typically not the highest safety rated papers).
VK: Does one really need to invest in multiple funds? Or, is there just one kind of debt fund – kind of diversified fund that I can invest in and be done with it?
AM: The choice of investing in debt funds depends upon the risk taking appetite and time horizon of investment.
As mentioned before, there are different categories of debt fund, which have a different amount of risk embedded in them.
Interest rate risk is measured by duration. Higher the duration, higher the risk.
Let’s refer the table below for 1 year holding horizon of various debt categories. It shows various return probabilities assuming a change in yield at the end of 1 year and a parallel shift in yield curve.
[Parallel shift in yield curve – “A shift in economic conditions in which the change in the interest rate on all maturities is the same number of basis points. In other words, if the three-month T-bill increases 100 basis points (one %), then the 6-month, 1-year, 5-year, 10-year, 20-year, and 30-year rates all increase by 100 basis points as well.” via Nasdaq.com]
[100 basis points equals 1%]
[YTM stands for Yield to Maturity.]
The table shows that higher the duration, higher the volatility. However, as your investment time horizon increases, the volatility reduces as interest rates movement has a terminal end in every cycle. So the accruals to the portfolio add stability and earnings post the interest rate movement period.
For making an investment in 1 fund (assuming all season fund for longer investment horizon, – typically 3 years), one can look at moderate interest rate risk category like short-term funds as these have in the past delivered decent returns over longer period even during rate cycle changes.
VK: That was great. Now, I have also heard that there is an inverse relationship between the interest rate and the price of debt instrument. What exactly does it mean and why is it so?
A related question is why does the NAV of a debt fund go up and down like equity? Isn’t it debt – like fixed income/deposit?
AM: Interest rates movement is inversely proportional to price of debt instrument. In case the interest rates come down, the price of bonds go up and if interest rates go up, the price comes down.
[The debt fund holdings are marked to market (MTM), to reflect the current market value of those holdings.]
To do this, the Net Present Value (NPV) concept is used. Assume you buy a debt instrument maturing after 10 years @ 8% coupon, and the interest rates come down by 100 bps (or 1%), then the present value of your asset increases (numerator earns coupon @ 8%, and denominator discounts it @ 7%). Hence the price i.e. NPV goes up.
Inversely, if interest rates go up by 100 bps, then the present value of asset comes down (numerator earns coupon @ 8% and denominator discounts it by 9%). Hence the price i.e. NPV goes down.
This concept works in debt funds. The duration of portfolio results in profit / loss in case of interest rate movement. This Profit / Loss is in addition to the regular earnings (accruals @ YTM) of the portfolio.
The volatility in NAV is driven by the interest rates going up and down and a resultant change in the NAV.
VK: What is the most important thing to keep in mind when investing in debt funds?
AM: As mentioned earlier, one has to keep in mind the risks embedded in a portfolio. Interest rate risk and credit risk are main risks in a debt portfolio. We have discussed the duration risk above (interest rate risk).
As far as credit risk is concerned, let me throw some further insight. Now Mutual fund schemes invest in varies types of debt papers i.e. money market papers like CD / CP, corporate debt papers, sovereign papers and structured obligations. All these debt papers have a certain amount of credit risk involved, which is generally measured by the rating of such instruments.
For long-term papers (more than 1 year), the rating scale is AAA / AA+ / AA / AA- / A+ / A / A- / BBB+, and so on in that order. Higher credit rating represents higher safety servicing of debt and repayment. Lower the rating, higher the risk.
So one has to keep in mind the credit risk of portfolio by looking at the ratings, while investing.
Credit oriented funds typically have higher accruals and are relatively low on interest rate risk, but one can incur high losses in case of default.
Highly credit safe portfolio (AAA/AA+ rated) generally would have higher liquidity (market acceptability is higher) and thus during phases of volatile systematic liquidity, credit safe portfolio’s would have lower impact risk.
VK: What should I be wary about while evaluating a debt fund? The risks? How do I know about them?
AM: One can measure interest rate risk by looking at “Average Maturity” or “Modified Duration” of the portfolio. Higher the duration, higher the interest rate risk. Credit risk can be measures by looking at credit rating of the portfolio. In case the fund rating is not available, once can analyse the proportion of the portfolio invested under various credit ratings.
While interest rate risk is a systematic risk, credit risk is rather unsystematic. The unsystematic risk can be mitigated through diversification. Hence, one can look at investing in good credit quality diversified portfolio to reduce unsystematic risk.
VK: What should I never do when investing in debt funds?
AM: One should never under-estimate or over-estimate a risk. Also, one should not try to time investment / exit based on sentiment. One should always focus on risk taking appetite and investment time horizon, and choose funds accordingly.
VK: How do you go about managing debt funds? What’s your day-to-day work like? How do you go about identifying the investments?
AM: Managing debt funds is as complex as any other asset class. There are many moving variables affecting debt markets. These are both global and domestic, macro (such as Central Bank policies, movement of capital flows, risk-on / risk-off trades, structural policy changes, currency movements etc.) and micro (such as inflation, deficits , money supply, etc).
So one has to be hands on with all these variables on a real-time basis. One has to assess impact of variables on markets, and then engineer one’s portfolio with these moving variables (if required.)
On a day-to day basis, we generally go about scanning macro variables, both domestic and global. Then we scan the micros. Once this is over, we check on our portfolios, if any changes are required. Cash flows (purchase / redemptions) obligations are to be met on a daily basis, so generating cash / deploying cash is next step. We scan markets for rich / cheap analysis, check buying selling options based on this. We spend time on research, both credit and economic.
VK: That sounds like quite a bit. I guess people like me would be better off choosing debt funds than track and manage all this activity themselves.
AM: I firmly believe debt should be a part of investment portfolio. Debt funds provide a good route to that objective.
I am happy to see your efforts in educating investors to that end.
VK: Thanks Akhil, that is what we exist for – to empower individual investors with knowledge. Finally, one last question. Why are you a debt fund manager and not anything else?
AM: (Smiles) I guess this was meant to be. My liking for economics and number crunching were main reasons for bent of mind towards debt.
Thank you Akhil. It was wonderful to have your views. I hope the readers appreciate this perspective coming straight from a specialist like you.
Disclaimer: The above content is purely for educational purposes. The views expressed are in no way to be construed as investment advice or promotion of any particular investment or fund. Please consult your investment advisor to know what best suits your profile.
You can invest online in debt funds with Unovest. Have you created your account yet? Click here.
It would be good to see some recommendations for debt funds that give high returns, at the cost of high risk. I know of only the Franklin India Income Builder Fund.
Are you sure long duration bonds give a high yield? I read the opposite in many places. For example Morning Star says that Long-term government bonds (the only type of long-term bonds available) perform worse than corporate credit bonds, short-term bonds and ultra-short-term bonds. Go to http://www.morningstar.in/tools/mutual-fund-category-performance.aspx and select a duration of 10 years.
Yes Kartick, will work on a list like this.
As for the question, the returns depend on several factors and can vary over periods. The Morning Star data you refer to is about the category average. There were funds that did better too. Fund management skills at play here, probably.
Will have to dig deeper into this.