Bond Yields Are Surging. What Should Be Your Debt Funds Strategy

Mar 2, 2021

It is a common misconception among investors that debt instruments and debt funds are stable and safe. But the fact is debt or bond markets may not be the best place for low risk, light hearted investors.

Debt instruments carry various kind of risks, such as credit risk, interest rate risk, etc. and can be impacted by changes in macro-economic outlook.

In the last few years, bond markets have witnessed many instances of credit defaults, leading to loss of investors' wealth in debt mutual funds. Many investors even saw their debt schemes winding up overnight, which blocked access to their money in these funds.

Currently, the investors are concerned about the sudden fall in NAVs of their debt funds. Bond markets are going through a phase of surging bond yields which has had a negative impact on the bond prices and NAVs of debt mutual funds.

The reason behind the surge in bond yields...

The Union Budget 2021 focused on pro-growth measures and making structural reforms to get the economy back on track. It provided an extensive spending plan on long-term projects including infrastructure, capex, and healthcare, which comes at a cost of higher fiscal deficit.

The increase in the fiscal deficit target and higher borrowing program the government announced in the union budget has altered the sentiments in bond markets.

Notably, the government has projected a gross borrowing of Rs 12.05 trillion for the FY 2021-22, which is much higher than the expected Rs 10.5 trillion. Moreover, the government plans to borrow an additional Rs 80,000 crore during the remaining months in the current fiscal year.

The increase in borrowings in the current fiscal year will lead to an increase in supply of government bonds to the extent of Rs 80,000 crore, which might suppress the bond prices, thus causing a spike in yields. Moreover, the higher borrowing target for the next fiscal year will continue to push bond yields higher.

As you may be aware, bond prices and yields are inversely related. A surge in yield will impact bond prices negatively, thus causing a loss to the investors' value.

Bond yields have already seen an upward bias despite the RBI's assurance that it would provide ample liquidity and ensure a smooth government-borrowing programme. In the month of February 2021 alone, we have seen the NAV of debt funds declining up to -3.7% (absolute), thus diminishing investors' wealth.

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Is the rally in bond markets over?

The COVID-19 crisis and series of lockdowns had obstructed business activities and economic growth. As a measure to fight the crisis, the government announced a series of salvage packages.

On the other hand, the central bank supported the economy by announcing various liquidity measures to aid credit flow to needy sectors and ensured monetary transmission. It tried to support the economy by reducing rates, extending liquidity support to some of the financial institutions, providing moratorium on term loans, and so on.

In all its recent monetary policy meetings, the RBI indicated that it will continue with the accommodative policy stance as long as necessary to revive growth on a durable basis and mitigate the impact of COVID-19 pandemic. It had another challenge of bringing inflation within the target range of 2% to 6%, which remained well above its upper limit of 6% for a long time.

Notably, the central bank reduced the repo rate by 115 bps and reverse repo rate by 155 bps during the pandemic. The fall in yields to a multi-year low led to a rally in bond prices; however, with yields at an all-time low, the return expectation on debt funds diminished. Moreover, the margin of safety reduced at the longer end of the maturity curve.

The longer duration instruments are more sensitive to interest rate changes as compared to shorter duration instruments. Debt funds having exposure to medium to longer duration instruments tend to be more volatile in a scenario where there is an upside movement in interest rates.

The rally in debt funds is almost over though and we may not see a rally any time soon. One needs to be cautious and have a reasonable yield expectation when investing in debt funds.

Debt funds, having exposure to longer maturity instruments, may be highly volatile going forward, while those focusing on shorter maturity instruments and following an accrual strategy may be still better-placed to tackle the interest rate risk.

Key checkpoints while evaluating debt funds:

While investing in debt funds, the primary objective of most investors is to generate decent returns while keeping their principal intact. But many investors fail to make the right choice on the debt funds category that can meet their objective.

Investors often ignore these basic checkpoints and end up investing in debt funds that are unsuitable and expose them to unnecessary risk.

While selecting debt funds you should not ignore these primary checkpoints:

1. Portfolio Duration and Average Maturity: Debt Mutual Fund categories are divided into 16 buckets. While most of them are defined on the basis of Macaulay Duration, some are differentiated on the basis of Credit Quality and type of instruments they invest in. You should pick debt funds that have a portfolio duration in line with your investment time horizon. In a rising interest rate scenario, longer duration funds would show higher volatility as compared to shorter duration funds. You should stay away from longer duration funds if you have a shorter time horizon.
2. Credit Quality of the Portfolio: While picking debt funds, many investors give higher preference to past returns. They fail to check the reason behind higher returns the fund generated. Questions you may want to ask are, was it driven by a smart portfolio strategy, or was it because the fund manager chased higher yields by taking higher credit risk? You should consider your risk appetite while evaluating the credit quality of the fund's portfolio. Do not fall for debt funds having higher allocation to moderate rated instruments or those investing predominantly in instruments issued by Private issuers. If your preference is safety over returns, you should consider funds primarily focusing on Government and Quasi-government securities.

At PersonalFN, my debt fund recommendation service DebtSelect is backed by a stringent rating process where I give more weightage and emphasis on the credit quality of fund's portfolio, instead of performance. The funds focusing on high yielding instruments issued by moderate to low rated private issuers score low on our SMART Score matrix, and are thus rated lower.

1. Yield to Maturity: Many investors fail to understand the logic behind higher yield to maturity. Ideally, instruments offering higher yield carry higher credit risk, or have a longer duration and come with higher interest rate risk. So if you compare debt funds on the basis of YTM, you should not ignore the level of risk it indicates. Debt funds having a portfolio with higher YTM may be carrying risk instruments that are suitable only for investors with a higher risk appetite, i.e. those willing to take higher risk for higher returns.

Under DebtSelect, I give preference to funds having high quality portfolio with focus on Government and Quasi-government instruments. I avoid funds that aim for higher yields by taking higher credit risk with substantial exposure in instruments issued by private issuers. I consider private issuers to be more vulnerable to credit crisis, compared to Government and Quasi-government issuers that offer relatively lower yields.

1. Historical Performance and Risk-Reward: Historical performance is an indicator of the funds' success and cannot be ignored. However, one should not look at performance in isolation. The above parameters are equally or I would say more important when picking your debt fund. While considering the performance, evaluate the funds' performance across various time periods and where it stands on the risk-reward scale when compared to its peers. It is not necessary that those topping the performance chart may be best suitable for you. Do not hesitate to give the fund a miss if its higher returns have come by taking higher risk.
2. Fund Management: At PersonalFN, we give higher importance to the investment systems and processes, along with risk management at the fund house. It is important to understand the overall philosophy of the fund house; whether they aim to create wealth for investors, or are they in a race to garner more AUM by showcasing higher returns generated from chasing higher yields and taking higher risk. You shouldn't ignore the fund management and background before committing your hard-earned money.

What should be the strategy for Debt Fund investors?

These are testing times for debt mutual funds, as the interest rate risk is higher, especially for those having allocation at the medium to longer end of the maturity curve. Moreover, funds having exposure to moderate and low rated instruments and those issued by private issuers may be riding on a double-edge sword of interest rate risk and credit risk.

It is important for you to understand your preferences, time horizon, and risk appetite, and make the right choice of funds.

As an investor, you need to first check if you are looking for safety of capital or returns? If your preference is safety, then stick to liquid funds that focus on Government and Quasi-government securities. Liquid funds chasing higher yield by investing majorly in instruments issued by private issuers can be ignored because they may expose you to credit risk.

As the interest rates are currently at a multi-year low, the interest rate risk will be higher for funds having their major allocation to medium / longer-maturity instruments, including Gilt funds.

Funds focusing on longer duration instruments have an average maturity typically in a range of 5 to 10 years, and are highly vulnerable to interest rate risk. Their exposure to longer maturity instruments may lead to higher volatility in a rising interest rate scenario. Notably, they do well in a falling interest rate scenario, but may lose significant value in a rising interest rate scenario and hence may not be preferable at this point.

Investors with a longer time horizon may primarily consider a mix of safely managed Dynamic Bond Funds and Banking & PSU Debt Funds. Any allocation to medium or longer duration debt funds should be limited to around 20% of the debt fund's portfolio, considering the higher volatility (due to interest rate risk) in this segment. It will be best to consider investing via SIP / STP to average out your purchase over a longer time period, while investing in debt funds.

You may also set aside some funds in safe liquid funds (around 20%) and can scale up your investments in Dynamic bond, Banking & PSU Debt Funds, and Gilt Funds through additional purchase when the interest rates show a sharp upside move.

This way you could gradually build a long-term debt fund's portfolio as well as minimise the interest rate risk when the interest rates are trending upwards.

PS: If you are looking for quality mutual fund schemes, you should try PersonalFN's premium research service, FundSelect. Currently, with your subscription to FundSelect, you could also get Free Bonus access to PersonalFN's Debt Fund recommendation service DebtSelect. Read full details here...

Author: Vivek Chaurasia

This article first appeared on PersonalFN here.

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