Positioning of Debt Fund

 

Positioning of Debt Fund 

Debt fund is for any short term need and not for long term need. This short term can be if required anytime within next 3 years and may be for retirees if required anytime within next 5 years. 

Why Debt in short term: Safety of capital, regularity in income is important in short term. This can come only from debt and not from equity. Any debt instrument and debt fund have clarity on cash inflows because coupon income is pre-decided, frequency of coupon income is pre-decided, receipt of maturity amount by or at maturity is pre-decided. Nothing is pre-decided in case of equity or equity fund, and all depends on fortune of the business. Further when you look at the risk also which can impact the cash flows there also in case of debt it is clear to judge from credit quality, cause and trend of inflation, level of interest rate and probable action of RBI MPC. In Equity again since sentiment dominates over logic in short term, measuring the changing sentiment and mood of market where billions of participants are involved is not easy. Even the best of blue-chip stock prices goes down in short term. 

Why Debt not in long term: Inflation is the biggest risk of money. Longer the period the impact of inflation is also more. The purchasing power of money gets reduced more in long term than in short term. Further if you look the long trend of the safest of debt products (PPF, NSC, PO schemes Bank FDs) the rate of interest has gone down decade by decade. See the trend from 1980s till now. What will be the trend going forward in long term? 

My assessment is it will keep declining further. My assessment is backed by a sound logic. No borrower wants to pay higher interest rate (Do any one of us want to pay more interest rate or less in case of home loan, car loan, education loan etc? Government is the biggest borrower in any economy. Borrowing is always done either when left with no choice or giving me ROI from my investment (e.g: I am paying 8% on home loan and getting 9% as return from investment). But government does not invest like you and me.

We all know Government borrows either to reduce the revenue deficits (Expenditure is more than income) or for some spending (capital expenditure, social benefit expenditure etc). So, in expenditure, interest payment on Government securities is also a component. . More the borrowing more will be the interest payment outgo. The other way to reduce the borrowing is increase the income (tax revenue, dividend from PSUs etc). 

Now look at the trend of GDP growth and tax income at government end. The trend is increasing only (exception Covid period). So, it’s natural that if income increases borrowing is not a compulsion. RBI borrows for Government and RBI also decides the policy rates which are an indicator for interest rate level within economy. 

Growth of economy is a natural desire and taming of inflation is a compulsion. That is the reason in short term interest rates move in any direction within a range (mainly to counter inflation) but in long term interest rates are reducing as lower cost of capital i.e. interest rate augments growth which everyone likes as borrower (Government, Companies, you and me). 

So, is there any incentive for investing in long term in debt when notional interest rate is declining, impact of inflation will be more and maybe I end with low or negative real interest rate. 

Which type of fund to choose: Within debt fund apart from credit quality also we know risk varies as per maturity. Longer the maturity more is the risk. SEBI has defined debt many funds on Macaulay Duration basis. Macaulay duration can be understood simply as average payback period. For e.g for Low duration fund the Macaulay duration is between 6 months to 12 months. It can be interpreted that though the fund manager has the flexibility to invest money in debt instruments of varying coupon, frequency of coupon payment, maturity, ratings etc but on the weighted average method all the cash inflow in the fund must come within 6 months to 12 months. Each cash flow is calculated on not what will be received but what will the present value of that cash flow considering that money has a time value risk and it is done after discounting it with present yield. 

One should ask himself when he wants his money back and match it with the Macaulay duration of the fund. Let’s say someone wants after 7 months. Now he has 2 funds to choose from: Ultra short duration fund (Macaulay duration 3 to 6 months) or low duration fund (Macaulay duration from 6 to 12 months). Both seems fine but as an investor I will prefer Ultra short duration or may be mix of both. Reason for preferring Ultra short duration is my horizon is near to it as compared to low duration (What generally we do like in Fixed Maturity Plan or FD). 

Should one try to time looking at interest rate trend: Debt fund should always be positioned as strategic asset allocation (matching horizon with Macaulay duration) and not tactical. Many experts I have seen suggest different fund for investment looking at interest rate level and trend. 

My view is very simple for what I am taking the risk? For some big return? When you look all past RBI policies rate changes it has been mostly within the range of 25bps (0.25%). Even it has gone for 50 bps how much change it will have on the NAV. Please remember if the fund size is big the risk or the change gets absorbed easily but if the fund size is small then the change can be seen more. 

Also, when I see same fund return for different time horizon (e.g: Low duration fund 1 month, 3 month, 6 month return…….) the change is not much and this small change is more in shorter period and as time period increases this reduces and become negligible (Remember normal yield curve which is upward slope). Also, when I see the change for same time period (say 1 or 3 months) for different debt funds (Liquid vs UST vs ST………) there the change is more in higher maturity fund as compared to shorter maturity fund. The risk here is if I choose to say, mid to long duration fund over ultra short duration fund because there is possibility of lowering in interest rate leading to more MTM gain in longer duration even if I require after 7 month then what might happen if my call goes wrong? 

Another angle is the impact of interest rate risk get nullified by reinvestment risk (e.g: if interest rate goes down from 8% to 7 % leading to MTM gain then the cash flows which will come from existing coupon income and also fresh inflow will get invested at 7% and not 8%). 

Lastly even if I get some small gain how much ultimately is left with me after paying short term capital gain tax? So, based on all these logics why to take unnecessary risk of being tactical. Let this job remain with the fund manager who will take advantage of such situation.