The Mutual Fund Show: How To Build A Debt Portfolio

Singh: We have had so many queries whether debt funds are safe or not. Actually one thing is there that till now people have been buying debt funds as a proxy to fixed deposits. It is not the case. It cannot be a proxy to the fixed deposits but it is a smart way of saving money and putting money in fixed coupon products through a mutual fund route. So one good thing is with the crisis which happened in the market, people have really understood the risks involved in it. Earlier, whatsoever our efforts, people were not able to understand the risks involved, but the risk has to be mitigated. This has clearly come out that who is able to mitigate the risks involved and who is not. There is some risk involved and the mitigation of risk is definitely possible. I think now people can take a much more proper decision about their money while putting it in debt funds or mutual funds. It’s just not as a replica, but as you said because of something going wrong in a fund house, it’s impacting the whole industry and all the fund houses are impacted.

Singh: It should be understood. The problem is when the people don’t understand this. There is a very thin line between an almost assured kind of product like FMP (fixed maturity product) and putting it in a very safe kind of instrument. There is hardly any difference and there’s a higher rate of return, higher tax efficiency and so on and so forth. But the problem is, people have to understand. It has to be sold like that. The problem wasn’t selling and not even buying. So, the people who bought it, they bought it like a proxy for a fixed deposit. If you understand the product and buy it, then it is absolutely fine.

Nath: True. I think what has happened in the credit risk space in the last probably one-and-a-half years, right after the IL&FS crisis erupted, credit risk space has faced a lot of volatility. So, it was more to do with the people who are buying these funds and they were buying with a lot of expectation around returns and the fund managers also kind of fueled that by basically focusing on yields and kind of investing in a wide variety of papers, some of which ultimately turned toxic. So, I think the fund industry learned quite a bit. If I were to tell you global experiences, high-yield funds are a very large category. In India unfortunately, that category was gaining traction but because of mark-to-market losses and other things that category is virtually now is not going to grow any further at least for the next few years. But as a category, that’s not a bad to me. So if you were to look at our five-year track record of a credit risk fund, it’s still giving you a 7-8% return. So it’s not that it did not give returns, the returns were pretty good. And in fact if you look at the returns from May onward till now, again those are matching any of the AAA-rated funds because there were certain mark-to-market losses and that does not basically affect the underlying quality of the fund. Most people look at short-term returns in a mutual fund for one month or three months or six months, and they kind of form an opinion about these funds for longer, which probably is not the right thing to do.

Nath: Generally speaking on behalf of the industry or mutual funds, if you were to look at where the maximum impact was felt, most of these companies were actually AA or AAA-rated companies. IL&FS was AAA, Dewan Housing was AAA, Essel Group was AA, Vodafone was AA. Syntax was AA minus. Actually the lower ones; single A or A minus or BBB, those companies actually have been performing much better. So it was not a question of credit quality or credit rating. It was more to do with an environment where suddenly there was a crisis of confidence, a liquidity squeeze happened and many of these companies actually got caught in that spiral. As a NAV, however, if you were to see, it’s not a bad category to be. In fact today if you see, credit risk is a very good credit category because let’s say for an investor who is conservative, who doesn’t want to take risks in equities, if a fixed deposit is generating a return of let’s say 5% on a post-tax basis and a fund can give a turn of say 7%, it’s almost like a 40% difference in returns, it’s not small.

I’m saying that if you look at a five-year return, actually the five-year returns are still better than a fixed deposit after all this volatility. These kind of crises happen once in 10-15 years, they don’t happen every now and then. I remember the last time this kind of crisis happened was in 2009 after the global financial crisis when some of these companies like Unitec got into trouble. And then we are facing the crisis now. So, these kinds of things don’t happen very normally. Maybe the industry will or the investors as well as advisers will be more enlightened and they’ll sell these products with the right kind of risk parameters. So, as a category I think it’s important.

There are two parts of it. One, when we are talking about graduating from the bank deposits. When we are graduating from bank deposits, SEBI has rather done a very sensible thing of putting categorisation in a very clear-cut manner. So, if the money is to be kept in a savings bank account because it’s uncertain when I will require that money back, then that kind of fund cannot be put in a long-term credit debt fund. The money has to be in the lower side of the category; that is either you have to put your money in a money market fund or the low-duration fund because volatility will be much lesser and whenever you need money, you will get better than the savings bank. If your money is going to be say for one to three years, then there are funds where you can put in money; it’s either a short-term fund or a medium-duration fund and if the money you want to park in a fixed deposit for three years plus, then that money should definitely come into a corporate bond fund or an income fund or a dynamic bond fund kind of category.

Second, the argument that if you have to risk, why shouldn’t be in equity, I think that it is not the right kind of comparison. Reason being, yes this credit risk fund or whatever we’re discussing is definitely an one-off, there was a flurry of activities for a few months. But most of the funds forget that there is a storm. When I’m saying debt fund or a mutual fund that cannot be one, it has to be in one or two or three categories.

Singh: First things first, people should not put in money in these funds, even in the debt category, by looking at the returns which have been generated in the last one year. The reason being, there has been mark-to-market gains and the yields-to-date have been totally different. There has been a rally of 100-150 basis points in the last one year, this is not likely to happen now. But yes, there’s an interest rate bias, there will be some capital appreciation but the returns, if we look at the yields and we add up to 50-100 basis points more, then definitely the returns will be much better than the fixed deposit rate. In a scenario, suppose the interest rate doesn’t move downwards, then the returns would be almost equivalent to bank deposits or whatever the yields minus expenses are. So that exactly is the problem. When we are selling debt funds or advisers are advising debt funds, those set of investors do the math. They know the risk involved in all this and they will never go to the last one-year returns and sell it to anybody. I’m not saying that some distributors will, but may due to the lack of knowledge. So people have to understand that these are very good funds. If you are putting money in a gilt fund for more than three years, definitely, slightly the NAV cycle in a gilt fund; the rolling returns have been better than fixed deposits historically but there can be a situation where it can be less than that, there cannot always be these kind of returns, that has to be kept in mind. But yes, the probability of these funds getting better than fixed deposit returns are 80-90%.

Nath: First of all I think if a client does not have a tax issue with him; so let’s say a retired person; he doesn’t pay any taxes or pay only maybe 8-10% tax on his income, the person has limited income—for him, the only category which I would suggest which he should go for is a short-term fund or as Mr. Singh talked about low-duration funds because the thing is that for him the differential between a fixed deposit and a mutual fund will be very limited. So obviously, these three-year returns as Mr. Singh said, they are largely affected by the kind of rally that we have seen in interest rates because interest rates got cut and therefore the bond prices went up. We are not likely to see that same kind of intensity in the next three years. That there is a higher probability that in the next three years interest rates may actually go up and therefore instead of seeing an 11% return, you may see a 4-5% return. So for a person who doesn’t have a tax arbitrage issue, sticking to a bank fixed deposit may make more sense than investing in a mutual fund with volatility, but where tax arbitrage is an advantage because let’s say somebody is paying 30% tax so 40% tax or 42% tax, for those people mutual funds offer a very real alternative. As far as for as long term money, of course you should into gilt funds or dynamic bond funds and all that. For shorter duration, let’s say a one year or two year money can go into short-term funds and low-duration funds. When you’re looking at a gilt fund, you’re trying to basically bank on the interest rate cycles. So, you need to basically be on the right side of the cycle. If you go wrong, then for some years one year or two years your return may be below that but if a smart investor understands that these one or two years I can live with; as long as my seven years or eight year returns are good and better than fixed deposits, then I think those long-duration funds can make a lot of sense.

Singh: The returns shown are not point to point returns, these are SIP returns. If somebody is putting money in the SIP route in a liquid fund, then that’s a very good return because it is capturing all the cycles. Standalone, the return might be much better. It could be higher than this also. Whereas the FD returns are taken as static as it will not change.

Singh: This banking and financial services fund is not a debt fund. It is an equity fund. As far as safety is concerned, safety will definitely be in line with the banking index. If we were in the financial sectors and banking stocks do well, the funds will definitely do much better because the funds are being part of a lot of research in various bank stocks and various NBFC stocks, and the track record has been very good. So, the question is whether is it safe to park money? It is safe to park money as there is a debt fund called a banking and PSU fund. So that’s a separate thing.

Banking and PSU in the debt category is definitely safe. I would consider it safer than other funds. Banking and financial services is a thematic fund which is riskier than the other large-cap funds or other multi-cap funds. It is a risky category, it will depend upon the fortunes of that sector doing well.

Nath: I think because it’s called banking and financial services, maybe people are confusing it with debt and not equity and therefore this question whether it’s safe. As Mr. Singh pointed out, it is a pure equity fund. So, when you’re dealing with pure equity fund you should be concerned about the volatility, the safety basically. Of course these funds are of the highest quality funds available in the market place. So if you look at underlying portfolio SBI banking and financial services, it will have all the top banking and financial services names of this country—whether it’s a State Bank of India or HDFC Bank or ICICI Bank or Bajaj Finance and Kotak Bank. All these are the top names in the country so your money is safe, but it’s volatile. Therefore, if you are investing for 5, 7-10 years period in these kind of funds, then because these underlying stocks of these banks and financial services which are obviously leaders in this space, they are going to grow. So the money will also grow but it will grow with a lot of volatility unlike a debt fund as Mr. Singh clarified. A banking and PSU fund is a category in itself in the mutual fund space now and which is investing only in the profitable banks of the country and profitable PSUs of the country. So, these are AAA-rated portfolios and the safest of the lot available. So it’s probably a little higher in terms of safety than a pure corporate bond fund which will have a lot of private sector corporate because generally banks and PSUs in the country are considered to be much safer than a corporate when they are a AAA. So, that’s the highest quality category in the country in terms of fixed income.