Debt Mutual Funds: Duration Funds vs Accrual Funds

A debt fund holds debt instruments, and these instruments pay a particular coupon (interest). An accrual strategy is holding a bond, earning the interest due, collect the principal at maturity and reinvest it in fresh bonds. Liquid funds, ultra-short term funds, short-term debt funds, income funds and credit opportunity funds primarily follow an accrual strategy.

A fund following a duration strategy seeks to gain from bond price rallies when interest rates fall. When interest rates fall, bond prices rise – since new bonds will carry a lower interest, existing bonds become more attractive and thus prices rise until yields match the new bonds. A duration fund will try to make capital appreciation from the bonds it holds.

An accrual fund does not try to time the interest rate cycle. Given the rate scenario and its own mandate, it will look for those instruments that deliver an optimal yield. A duration fund, on the other hand, will estimate the direction interest rates will move and adapt the portfolio to maximize the chances of bond price appreciation.

Duration potential is felt the most in government bonds (sovereign bonds or G-secs or gilts). Gilts are the most liquid debt instruments and also among the few instruments with very long maturity (10-20 years). They tend to therefore reflect rate cuts and rate cut expectations the most. Therefore, a duration fund will load its portfolio with gilts when it anticipates rate cuts. If you see a debt fund holding a large proportion of sovereign bonds, you will know that it is playing duration. These funds will have high average maturities (usually above five years). As gilts don’t pay high interest, the yield-to-maturity of these portfolios will be low. Investing in gilts is for the capital appreciation they offer and not for the interest component.

An accrual fund will primarily have corporate bonds or NCDs, commercial papers, bank bonds and certificate of deposits. It will have minimal to no holding in gilts. Depending on the type of accrual fund it is the average maturity of the portfolio ranges from a few weeks to a few months to a few years. Depending on the fund, the yield to maturities will be higher than duration funds.

When rates are falling duration funds delivers more than accrual. Accrual funds too use duration strategy in a falling rate scenario (as the top-rated corporate bonds they hold can be traded) to push up returns.

Duration funds are inherently more volatile. As bond yields and prices fluctuate on both actual and expected rate action, the NAVs of the funds will also fluctuate. Funds also actively manage the portfolio, upping or dropping the gilt holdings, adding to volatility. Apart from the volatility, the risk is that the fund gets the interest rate call wrong. These funds are generally meant for holding periods of more than two years.

Accrual funds have lower volatility. But they aren’t automatically lower risk than duration. Risk in accrual funds comes in when the funds hold debt instruments that are of lower quality or credit rating, called credit risk. Funds take this risk for the higher coupon such papers offer. Rating downgrades hit bond prices and thus NAVs. Defaults by shakier companies, though rare, can cause losses. So when picking an accrual fund, you need to be careful and look at the portfolio.

In some accrual categories, the credit risk is more or less clear. Liquid funds stick to very short-term papers of the highest quality. Income funds are meant for holding periods of over two years and these funds take limited to no credit risk. Credit opportunity funds make it a point to take high credit risk. It gets tricky in short-term and ultra-short term funds as some take credit risk in various degrees and some do not.

Duration suits investors who can take bouts of volatility in their debt fund returns. Dynamic bond funds are the best since they change their portfolio and strategy as per the rate scenario leaving little to do on your part other than sit tight. Gilt funds need timed entry and exits as duration works only on falling rates and thus suit only informed investors. Accrual suits moderate and conservative investors as they do not have much volatility and are stable.

Sabyasachi Paul has been associated with equity research and advisory on equity markets in India for over 9 years & currently heads the equity research desk of Eastern Financiers Ltd, Kolkata.He also manages a portfolio on the online platform Kristal. Find link to the strategy named ‘The Tortoise’

What is driving liquidity in the markets?

The current rally in Indian market is fuelled by strong liquidity from domestic investors. With low bank fixed deposit rates, subdued real estate market (with high transaction cost) and stagnating gold prices, equities seems to be the most viable domestic investment avenue for investors. Thus in spite of the markets reaching all-time highs & rich valuations there is very strong cash inflows into the equity markets.
One observation is that domestic institutions have been flushed with funds ever since demonetization was announced and even till date the latest rally in equity markets is purely driven by excess liquidity. It may be a mere co-incidence but it could also be possible that the notes that were previously hoarded in homes & not in circulation is flowing into the equity markets after being deposited into banks.
Let us look at the different investment avenues in order of risk expected returns:

 

Product
Tenure
Returns
Notes
Liquid funds, ultra short term funds
Less than 1 year
6.5-6.7%
Safe. Liquidity with some extra return over normal savings a/c. Taxable returns.
Bank FD
1-5 years
6.7-7.2%
Safe & fixed returns. Marginally extra returns with liquidity but fully taxable other than 5 year FD.
Gold
3 years+
6-8%
Returns not guaranteed. Moves in contrary to equities & does well in times of global distress.
Debt funds
1-5 years
7.5-8.0%
Safe but returns may fluctuate. LTCG indexation if held more than 3 years.
PPF, SCSS, EPF, PMVVY etc
7.8-8.65%
7.8-8.65%
Safe & fixed returns. Extra returns but illiquid. Mostly long term government savings schemes.
Hybrid funds
1-5 years
9-11%
Marginally risky. Extra returns due to mix of equity & debt in the portfolio.
Real Estates
3 years+
10-15%
Risky, returns may fluctuate. Illiquid long term investment. Transaction cost of buying & selling is very high (12-15%) & lengthy. LTCG indexation after 3 years holding
Equities
3 years+
14-16%
Risky, returns may fluctuate. Capital appreciation, Liquidity. To achieve high priority long term goals. Tax free after 1 year.
The objectives above are in the order of priorities as well as return which means the liquid fund should be looked for first as liquidity then return, similarly while investing into equity one should keep the capital appreciation as top priority even if it offers liquidity that automatically sets condition for long term investing.
One should look at post tax real return i.e. (Real Return= Return-tax-inflation). Thus for each of the asset classes they should atleast beat inflation post tax to be viable. With inflation currently at ~3-4 all the above assets may be generating positive returns but bank FDs would be giving you the least post tax returns amongst all. (Assuming liquid funds are invested in for 3-6 months to take care of short term liquidity & not an attractive investment avenue).

Sabyasachi Paul has been associated with equity research and advisory on equity markets in India for over 9 years & currently heads the equity research desk of Eastern Financiers Ltd, Kolkata.He also manages a portfolio on the online platform Kristal. Find link to the strategy named ‘The Tortoise’ 

How do you lose your Capital?

What is Capital? Capital is our hard-earned money which we save over the years. The next question thus is- Why do we save? We save to meet our needs or goals in the future, or perhaps for contingency. Thus we invest the money we have with us instead of spending it, and wait for consumption for a later date.
Thus, the money that you earned today could have been spent today only but you chose to defer the consumption to a later date by investing the money. Thus the money that you saved has become your capital.
Now, suppose at a later date you intend to withdraw your money to buy something, the capital you had invested in the first place should have earned enough return so that you could have bought it in the first place. Basically, you are trying to protect the purchasing power of your money in the name of capital protection. What is the biggest risk to capital? It is the rise in prices or inflation. When we say protection of capital, in simple terms we mean that our capital should be able to grow higher than growth in our expenses. This is capital protection. If the rate of growth (returns) of the saved money (capital) is less than the increase in household expenses, then we are simply destroying the capital.
Therefore, the question that arises is: which investment option surely and certainly destroys our capital? The first choice of Indian investors is a financial asset called fixed deposits (FDs). Historically, net of taxes it has hardly ever beaten inflation. A person falling under the 30% tax bracket is surely to earn a post-tax return lower than inflation in the long run.
To cite a simple example, you want to take a holiday package for your family which costs Rs.1,00,000 today. But instead you decide to defer it & put the money in a FD at 7% p.a. After 3 years you will get Rs.1,22,500. After 3 years you decide to go on a holiday again but then it costs Rs.1,30,000. This is a simple example over a short period of time. Imagine what happens with your retirement savings over the next 20-30 years.
You may be saving 20-30% of your salary & suppose over your work life your savings earn say 6-7% post- tax returns p.a on an average (all your savings have been in options like FDs) while your expenses (read inflation) keep growing at 6-7% p.a. After that you have kids and you educate them and also marry them amongst other major expenses like buying a car or a house. When you retire, all you have is your ‘safe’ FDs. You have created some corpus but you may run out of capital by the age of 70. What will you do when you run out of capital at the age of 70? This is what bank FD does to your capital. There is no real growth in capital. Therefore, think beyond bank FDs they hardly beat inflation in the long run.

Sabyasachi Paul has been associated with equity research and advisory on equity markets in India for over 9 years & currently heads the equity research desk of Eastern Financiers Ltd, Kolkata.He also manages a portfolio on the online platform Kristal. Find link to the strategy named ‘The Tortoise’ 

How much to invest in Equities

One of the initial investment decisions that one has to make is what proportion of assets to invest in equities & what proportion in debt.
One of the basic thumb rules used over the years to decide on equity allocation is the 100 minus age allocation. The risk taking capacity of a person is maximum at a young age & keeps declining as the person gets older. Thus one should subtract the current age from 100 & invest that proportion in equities & the balance in debt.
This is just a basic thumb rule for guidance. It does not align with the financial goals of a person which are the actual purpose of creating a financial portfolio & building a corpus. Thus this rule may be a good starting point but various other factors like life expectancy, age of retirement, financial goals, other liabilities & risk profile of the investor should be considered before making the asset allocation decision.
Investment in equities can be done in various ways:
1. Invest directly into equities
2. Invest through an equity mutual fund ( again the fund can be diversified large cap focused, mid/small cap focused or sector focused & the risk-return will depend on the type of fund invested)
3. Invest in a Hybrid Mutual Fund (Balanced Fund/ MIP) which invests a proportion of your money into equities
Equity investments should always be made with a long term horizon of at least 5-10 years to mitigate risk. The short term fluctuations in the economy tend to even out in the long run & thus the higher the time period of holding the lower the risk. Also equity investments should be as diversified as possible not only across funds/stocks but also across time periods. As the saying goes ‘Never put all your eggs in one basket’. Thus one should ideally do a systematic monthly/quarterly investment in 4-5 mutual funds or 10-15 stocks or a combination of both and stay invested for more than 10 years.
One should always take specialized advice for building up your portfolio as per your profile & goals. Given a gradual increase in life expectancy globally over the years, investment in equities have gained importance to ensure that you get more out of your hard saved money and your money lasts longer than what it did previously.
Sabyasachi Paul has been associated with equity research and advisory on equity markets in India for over 9 years & currently heads the equity research desk of Eastern Financiers Ltd, Kolkata.He also manages a portfolio on the online platform Kristal. Find link to the strategy named ‘The Tortoise’ 

The Interest Rate Dilemma

On 1st April 2017 the Government announced a 10 bps rate cut across all small savings schemes offered, from Senior Citizen Savings Schemes to Public Provident Fund and mind you this is not the first cut over the last year when the government decided to revise small savings rates every quarter depending on economic/market forces. A decline in rate adversely affects millions of people invested in these schemes, especially retired people who depend on interest earnings for a living.
Every couple of months, whenever there is a RBI Policy review, we hope for a repo rate cut by the RBI. A rate cut would bring down the cost of borrowings for not only individuals having home loans, auto loans or personal loans but also large corporate who have bank borrowings.
Only if we could have a low interest rates for borrowers & a high interest rates for investors , but in reality it is not possible.Thus it is a fine balance which has to be maintained to satisfy both groups of people, the net borrowers & the net investor.
Nothing comes free of cost and is ultimately passed onto the final consumer. A high interest rate deters new investments by corporate, so new capacities don’t come and thus new jobs are not created. The cost of existing loans are high, thus they are passed onto the cost of the final product sold. A costlier product will mean higher inflation. High inflation and slow GDP growth is not good for the economy. That is why we always look forward to a rate cut by the RBI.
Possibly we should look at real returns from our investments (net of inflation) rather than the actual returns we get on savings. What is the point in the government assuring us 8% returns when inflation is at 10%? In the current scenario inflation is at 3-4%, the 10 year G-sec is hovering around 6.5-7% while the government is offering 7.9-8.4% on small savings. Thus we are earning more than 400 bps above inflation & the Government is paying significantly higher than at what rate it is borrowing. The government would be paying this additional rate from the tax collected, and thus as tax payers we should not be complaining about a declining interest rate.

At the end of the day, it all depends on which side of the coin we fall on. The interest rate dilemma is something which possibly cannot make everyone happy. But I still believe that given low inflation currently we are in a good situation with small savings interest rates currently.

Sabyasachi Paul has been associated with equity research and advisory on equity markets in India for over 9 years & currently heads the equity research desk of Eastern Financiers Ltd, Kolkata.He also manages a portfolio on the online platform Kristal. Find link to the strategy named ‘The Tortoise’ 

Interest Rate Fall- Think Beyond bank fixed deposits…

Though lending rate decline is good news for home loan buyers, decline in FD rates are making investors worry. With rates for deposits falling to 6-7% levels retail investors are feeling the pinch. So how to deal with a falling interest rate scenario and are there alternatives is what investors are thinking now. Mutual funds, NCDs, tax free bonds, small savings schemes and even FDs are fixed income avenues available to investors which need to be review whenever such scenario occurs.

Invest a part in equities 

Investors are advised to follow an asset allocation approach, wherein a portion of the investable surplus is invested in equities (direct shares or through mutual funds). Equities are for long term horizon and cannot be exited based on certain events. How much exposure should be taken in equity is factor dependent on age, time horizon of goals and investors. For example an aggressive investor exposure in equities with more than 10 years can go up to 60-70% while a conservative can stick to 25-30% in equities. In the long run historically it has been observed that equities can give about 14-15% returns on an average.

Restructure your fixed income portfolio
While a decline in interest rates is beneficial to home loan borrowers, it also brings down returns from bank fixed deposits. As bank FDs lose sheen, investors are forced to look at alternatives. Here are few options one can delve in:
Debt mutual funds- Not many investors are keen to invest in debt mutual funds. But it throws up opportunities in rising or falling interest rates scenarios. Debt mutual funds have various categories of schemes in which money can be invested for a time frame ranging from one day to more than five years. In a declining interest rate scenario debt mutual funds (dynamic bond funds/ Income Funds – which are holding longer term maturity papers) can provide excellent tax free returns. Debt Mutual Funds would have across various holding periods provided 9-11% returns over the last couple of years due to sharp fall in interest rates. Over the next year one may expect 8-9% returns & if held for more than 3 years returns would be largely tax free. For investment horizons below 1 year one may look at liquid/ultra short term funds, 1-3 years- Dynamic Bond Fund/Short Term Bond Funds and for over 3 years- Income Funds.
NCDs/Corporate FDs/Bonds- Non-convertible debentures/ Corporate FDs were in focus when interest rates were at peak and good companies came out with NCDs at rates higher than 10%. With rates falling now one cannot expect that kind of returns. A few companies are about to launch their NCDs. It is expected that they may come out with 8-9% interest rate. These interest rates are better than traditional deposits. Investors looking for steady income can find these attractive. However NCDs & Corporate FDs have their own risk which needs to be factored in your decision making. Ideally one should not go beyond 10-15% of their fixed income portfolio.
Small savings schemes- Despite their interest rates being reviewed regularly & declining, they are significantly higher than bank FDs. PPF offers an interest rate of 8%. Sukanya Samridhi Yojna Scheme (SSYS- for female girl child) offers an interest rate of 8.5%. PPF and SSYS investments are also tax exempted u/s 80C. Post tax return above 8% in the current scenario is good for fixed income portfolio. Senior Citizens Savings Scheme- SCSS also offers an interest rate of 8.5%, though taxable it is still attractive especially for lower tax slab retirees as one can invest upto a maximum of Rs.15 lakhs. These small savings scheme are a good bet considering the locking of interest rate for the long term or its non taxability.

Thus to sum up if debt/equity mutual funds are not in your portfolio till now have a relook. Do your homework and ensure that you at least beat inflation in your fixed income portfolio.

Sabyasachi Paul has been associated with equity research and advisory on equity markets in India for over 9 years & currently heads the equity research desk of Eastern Financiers Ltd, Kolkata.He also manages a portfolio on the online platform Kristal. Find link to the strategy named ‘The Tortoise’ 

Investment Objectives and Returns

How does it matter that most of the debt products give similar return of 8-10%, and then why not invest in only one product i.e. Bank FD for 10 years for which bank is offering about 9.5% for 10 years.
However a product needs to be understood from the point of view of the objectives they are supposed to meet on the basis of their tenure. The following table illustrates the fact to an extent:
Product
Tenure
Objective
Bank FD, Liquid funds, ultra short term funds
Less than one year
Liquidity with some extra return over normal a/c
Bank FDs, income funds
Up to three years
Extra returns with liquidity
Hybrid funds
Three years to five years
Better return than FDs, liquidity
Equity funds/Equity SIP
More than five years
Capital appreciation, Liquidity. To achieve high priority long term goals
The objectives above are in the order of priorities which means the liquid fund should be looked for first as liquidity then return, similarly while investing into equity one should keep the capital appreciation as top priority even if it offers liquidity that automatically sets condition for long term investing.
Let’s look at how as an investor we tend to behave. First of all people buy an endowment plan of life insurance which becomes a liability over next 15-20 years. The premiums are high for a miniscule life cover. To add to that the basic purpose of Insurance, i.e life cover is itself not served given the amount of cover it gives will not be sufficient to take care of the financial needs of dependents. Returns are so poor (6-7%) that I didn’t feel like putting it in the above table.
Bank FD which is for a short to medium term objective we keep it for 5-10 years, where as its primary objective is to offer liquidity with moderate returns. But what we liquidate the first is ‘Equity’, which is a long term investment and may take longer to deliver.
Now let us look at the returns part. Assuming that debt & FDs provide returns of 8-10% and Equity mutual fund will give 12% return, which is not a fair comparison in favour of equity funds because they have delivered much higher returns in the long run.
Product
Returns
Tax
Inflation
Real Return
1-3 years FDs
9%
30%
8%
-1.7%
Income funds 2-3 years
9.5%
20% (LTCG with indexation benefit)
8%
0.9%
5-10 years Bank FDs
9.5%
30%
8%
-1%
AAA Tax free bonds for 10 years
8.4%
NIL
8%
0.4%
Equity mutual fund for 10 years
12%
NIL
8%
4%
 Assumptions:
 · Highest tax bracket is considered
· Surcharge and education cess is not considered for calculation simplicity
· The above table is for illustration purpose only. The actual returns offered by Banks may vary
 The above table clearly suggests that when one is looking for returns, it’s the real return i.e. (Real Return= Return-tax-inflation). The table suggests that only equity has given positive real return over 10 years (other than income finds & tax free bands to a small extent). This does not mean that one should put all their money in equity. Equity also comes with slightly higher risk and a balance of risk & returns should be maintained. In addition the overall portfolio should be able to beat the inflation over longer period and for short term to medium term needs (read 1-3 years) liquidity should be the highest priority.
In the above table the assumption for equity returns has been taken as very conservative. Over 10 years period one should expect 14-15% return from this asset class. But ‘Patience is the key’. Life is a marathon so is equity.
 Very often investors pull out money from equity or discontinue their SIPs after 2-3 years to fund their medium term needs and most of the time at a loss by not giving enough chance to the asset class which has a huge potential to deliver great returns over longer period because they can’t touch or STOP their endowment life policy and the FDs which is of longer tenure.
 If one sets the priorities right as mentioned in the table and align it to the financial goals, journey should be very happy and peaceful.
Happy investing!
Sabyasachi Paul has been associated with equity research and advisory on equity markets in India for over 9 years & currently heads the equity research desk of Eastern Financiers Ltd, Kolkata.He also manages a portfolio on the online platform Kristal. Find link to the strategy named ‘The Tortoise’