The most common refrain that investors have for the debt component of their portfolios, in these times when interest rates are moving up, is what is appropriate. Since interest rates and bond prices move inversely, returns will be adversely impacted when bond yields move up in the secondary market. Sometime earlier, floating rate funds were popular and were considered an elixir for rising interest rates because it was expected that the Reserve Bank of India will hike interest rates and people drew a one-to-one correspondence that as and when interest rates move up, floating rate fund returns would move up too. At present, however, that idea is waning as recent returns from floating rate funds have not been as good as expected in spite of rising bond yields in the secondary market. One must note that nothing has changed fundamentally in the way floating rate funds are run.
There was a communication gap; when investors were lapping up the funds, they thought there would be ‘one-to-one’ correspondence between yields and returns. However, due to technical reasons, there may be a time lag between bond yields moving up and returns from floating rate funds moving up.
The usual advice that you will come across on various platforms, at this juncture, is to avoid long portfolio duration debt funds as those will be more volatile. That is correct. However, rather than the usual discussions on whether to go for floating rate funds or not, or choosing between long duration and short duration portfolios, let us look at it from a different perspective—your investment horizon.
You are entering the fund with an intended horizon of, say, one month or one year or 10 years. That is critical. But before we discuss this, let us understand a basic feature of how debt funds work, as that will give more clarity to the choices.
How Debt Funds Work
There are two fundamental sources from which debt funds earn their returns. One is known as accrual, which is the interest on the bonds and other instruments in the portfolio. The other is known as mark-to-market (MTM). Every day, the net asset value (NAV) of the fund is computed, based on the market prices of bonds and other securities in the portfolio. If bond prices have moved up (yields have come down) it adds to that day’s accrual, and vice-versa. If market movement is severe, it may add to or take away many days’ worth of accrual. Let us say that there is a bucket under a tap, getting filled with water. The tap is open and the water is flowing at a certain speed. It is possible to calculate how much time it will take for the bucket to fill up, at the given speed, and that becomes your expectation. Now comes the variable: it’s possible that a mug of water is taken away from the bucket. This means it will take that much more time for the bucket to fill up. However, there may be a windfall as well; a mug of water may be added to the bucket, which means the bucket will get filled in less time.
The rate or speed at which the tap water is flowing is the portfolio’s yield to maturity (YTM), which is the average YTM of the various instruments in the portfolio, and the nearest available proxy of the interest that is accruing. The mug is MTM; when yield levels or interest rates are coming down (bond prices moving up), they are added to the bucket, and vice-versa. If the market movement is mild, either on the upside or downside, only some volume of the water in the mug is added or taken away.
In short, if you have enough or more time for the bucket to fill up as per your calculation, then it does not matter if a mug of water is taken away from the bucket once or twice when the market movement is adverse. If you have time on your side in terms of the horizon for your investment, you can afford to smile. History shows that over a long period of time, bull and bear cycles play out. While once or twice water may be taken out from your bucket, once or twice it would be added as well. With adequate time, the tap water (accrual) itself will be adequate to fill up the bucket.
Required Time Horizon
The time horizon you require to enter a debt fund is a function of the portfolio maturity. As a ballpark guidance, and not as a hard-and-fast rule, having as much time as the portfolio maturity of the fund is adequate. For example, if it is a short duration fund with a portfolio maturity of, say, three years, you should have a three-year time frame. A timeframe of two or two-and-a-half years may also work, but something like six months will not.
The beauty of debt funds is that there are 16 debt fund categories, as per regulations by the Securities and Exchange Board of India (Sebi). Therefore, it’s likely that one or more fund categories are available to suit your time horizon. Accordingly, you may distribute your money into debt funds of various maturity buckets. This is known as laddering, where you have multiple cash flow requirements at various time horizons such as one year or three or five years, and you have matching investments to suit those horizons.
Getting data on portfolio maturity of a fund is easy. The portfolio or factsheet is published every month by all asset management companies, which you can access on their website. The variable here is that the data on the fund’s portfolio maturity is as on a given date (the last working day of the immediately preceding month). It may vary, as per the actions of the fund manager. From this perspective, Sebi has defined the contours of the 16 fund categories. In categories such as dynamic bond funds, portfolio maturity can vary widely. In most other categories, it has to remain within the defined parameter.
The reason why longer portfolio maturity funds are more volatile may be analogised with the movement of a pendulum. The bottom portion of a pendulum sways more, while the upper moves less. Similarly, for a given market movement, longer maturity funds move more (up or down, depending on interest rate direction) than shorter maturity ones.
To emphasise on the point of holding period and its significance, the most volatile among debt funds is government security (G-sec) or gilt funds. The reason is that though G-secs are the safest securities, the portfolio maturity of gilt funds is longest among debt fund categories. Studies show that over a long period, gilt funds have outperformed shorter-portfolio-maturity funds, in spite of higher volatility. This means that while a mug-full is taken away from your bucket in times of adverse volatility, a mug-full is added as well in times of favourable volatility. What must be noted here is that long horizon in this case does not mean one year or two years, but a decade or more. Pack your bags accordingly.