Debt Dilemma – what are the options?

Just a disclaimer: This is a fairly big note, where we try and analyse debt options available for investors and explain how returns are generated in Debt funds. And we are consciously releasing it post the MPC which leaves all policy rates unchanged. So read on, with time at hand!

Chronology:

Debt markets have gone topsy-turvy in the last 1.5 years. It all started with the IL&FS saga whereby the myth around safety and security of debt products got busted. The fact that credit ratings are mere indicators and not guarantors of an entity’s standing couldn’t have been better established.

And with every new episode: Essel Group, DHFL, CCD, ADAG, Yes bank etc – the cloud of uncertainty got deeper and darker. Then came the Franklin episode, proverbial straw that broke the camel’s back!

Months of March-April this year, saw huge withdrawals from not just the riskier credit strategies but even from the safest zones of Liquid/Money Market & Ultra Short funds.

Trust on NBFCs was at an all time low and investors flocked back to Bank deposits! Unfortunately, trend continues till date through a series of rate cuts which make the trade-off that much more lopsided and have led to super normal returns across debt categories in the last few months.

How to judge a debt fund?

One would reckon this is a fairly basic point but we think its extremely important to re-iterate. Objective of a Debt fund is to deliver positive real returns and to put it mathematically it could be Inflation + 1-3%

Debt funds can never be judged on absolute terms. And it’s unfortunate, that most investors think if a debt fund cant deliver 8% plus returns – its not good. This notion needs to be buried for good. Gone are the days of 6% Repo, 7% inflation, 8% deposits, 9% debt funds and double digit salary hikes. Bulk of the world today is at zero interest rates, deflation, salary cuts and correspondingly debt returns which are in tune with this new paradigm.

Before we launch into understanding what’s working and what’s not, lets have a quick look at the key data points which trigger all debate in Debt:

Repo	4.00%		6 month Bank FD	3.50%
Rev Repo	3.35%		12 Month Bank FD	5.00%
Savings Acct	3.00%		YoY Inflation 2020	3.34%

*YoY inflation is the adjusted rate for year thus far. This is likely to inch up for full year and end around 4-4.5% range. FD & Savings account rates are indicative averages across all big Private banks.

Important point to note here is that unless one is invested in a 1 year plus product – the real returns are negative. Which in effect means, that keeping money idle in Savings or in less than a year deposit is actually eroding your wealth adjusted for inflation.

How are returns generated in Debt funds?

So, are debt funds a suitable replacement in this scenario? Given the credit events and Franklin fiasco, can investors continue to trust this space?

Just to quickly summarise, debt returns are a function of:

1. Net YTMs of the portfolio –  Gross Yield to maturity less the expense ratio of schemes. This is also known as the accrual yield of portfolio.
2. Capital Appreciation – this comes through when the rates fall and correspondingly NAVs rise. In a falling rate scenario, this could be the most potent way of generating returns.
3. Spread Compression – Spread compression played through portfolio composition and mix of AAA vs AA or below rated papers.
4. Credit – This involves buying low credit rated papers to enhance the overall yield of portfolio.

For sake of brevity, we shall restrict this discussion to points 1-3 and keep the Credit part out as we have been unequivocally negative on any credit play in the current scenario. We continue to advise investors to stay away from Credit funds and portfolios with very high mix of below AA papers.

Making good returns is possible in debt funds even while avoiding credit play and last few months bear testimony to the same.

Let’s pick categories with negligible or zero composition of papers below AAA and analyse them for returns. If one looks at the YTMs of these portfolios, it looks abysmal. And going forward if one continues to look at the YTMs of debt portfolio (given the continued low rates and accommodative stance of RBI on policy front) – it can come down further.

*Returns are as of 31^st July, 2020. Source: AceMF. Approx Median category returns have been taken for sake of simplicity. Expense ratios are also indicative average taken for Category in Direct Plans.

As illustrated above, net YTMs across various categories of debt funds is fairly low. In fact, barely scratching above the inflation mark. But returns across categories barring overnight & liquid have been well above the inflation mark. And that’s simply on account of point (2) in case of Ultra short and Money market categories. Super normal returns in few other categories like Low Duration and Banking PSU Debt is a combination of both points (2) and (3) above.

We don’t do that often, but a proud pat is well-deserved, as we have kept our investors hooked on to these categories for almost a year now.

Spread compression:

About 3-4 months back, spread differential between Govt and corporate papers or between Sovereign and AAA papers, across 1 to 5yr band was hovering around 175-200 bps. This spread has now compressed to 40-75 bps range. This is one of the key reasons why short term categories (Low duration, Banking PSU etc) have yielded abnormally high returns in this time frame.

Liquidity leading to capital appreciation:

As the economy struggles to find its feet, low interest rate regime is here to stay for some time. Bank deposit rates will continue to come off and so will the YTMs of Debt schemes. But one thing, which will positively accrue to debt space is the surplus liquidity in the banking space, which in turn continues to compress the yields on short-end of the curve. Case in point being, call money rates which have now fallen to 2% from about 4% a month back!

So what categories benefit in this scenario?

This surplus liquidity is leading to yields coming off in the 3 month – 3 year spectrum across CD/CPs. We believe this scenario will persist and help Money Market/Ultra Short funds deliver returns which are 1-2% higher than inflation.

Liquid/Overnight categories seem exhausted. Regulatory changes by way of exit loads, stamp duty, portfolio instrument and maturity restrictions have taken its toll on the Liquid category. And one should only invest in this if the horizon is restricted to 1-3 months strictly.

For anything which is a year plus parking – Low duration could be the preferred zone now. Good quality low duration portfolios can result in returns from the first 3 combinations stated above (YTM + capital appreciation + Spread compression). Anything upwards of 2-3 years, can continue to go into Banking & PSU funds and also good quality Corporate Bond funds (credit evaluation is a must here).

Its critical to highlight that spread compression has a finite limit and yields coming off also can’t be a perennial scenario. Finally, these cycles will pause. And pause will mean, returns tapering to YTMs of portfolios.

So, our advice will be to treat each category to its matching tenor or average maturity being maintained by the fund. Use Money Market and Ultra Short only if the money is meant for 3-12 months tenor and not for anything above that. Because a holding period above that is also bound to disappoint. For holdings over 1 year – go to Low duration and Banking PSU categories as the case may be.

New category comes into play:

For investors, who find this complex and are looking for fairly assured returns – Corporate Deposits could be an option worth considering. Only point to consider here is that these are not as liquid as debt funds and pre-mature withdrawal can lead to significant yield dilution.

Rate of Interest Cumulative Option
Scheme	12 months	24 months	36 months
HDFC Ltd	6.41%	6.51%	6.56%
ICICI Home Finance	6.50%	6.75%	6.80%
BAJAJ Finance	6.90%	7.00%	7.10%
PNB Housing Finance	7.00%	7.00%	7.15%
Mahindra & Mahindra Finance	6.70%	6.95%	7.15%

*HDFC Ltd. rates are for 15, 22 and 33 months respectively. Above rates are for individual clients only. These rates are as of 31^st July and can change anytime. Senior citizens are eligible for 0.25% additional across all options above.

For the first time, we have got Corporate Deposits into the debt equation given the low YTMs across debt funds. We are optimistic on returns from yield & spread play but still cautious as those options have played out swiftly so far and it’s about catching the last loaf on the table now (or so we believe).

Corporate Deposits provide an assured way of touching inflation + 2% return on 1 year scale. Whereas, short term debt funds carry a promise to deliver inflation + 2-4% over the same time frame. Another benefit of Corporate Deposits is the removal of uncertainty (if the borrower credibility is not in question) in returns as the rate gets locked in. A healthy mix, depending on the objective of investors could be considered for the portfolio. Our team at Moneyfront, will be happy to help on this count.

To summarise:

• For 1-3 month parking – there is nothing but Liquid funds. No bank or corporate deposit is available for that tenor.
• For 3 -12 months parking – one can look at Money Market and Ultra Short Term funds
• For 1 year & beyond – it’s a mix of Corporate Deposits and Low Duration, which will work well for a portfolio.
• For 3 years & beyond – Banking PSU Debt funds, Corporate Debt funds and a healthy tossup of Corporate Deposits could work wonders.

Caution points:

• Don’t expect 10-15% returns to continue across these categories for next 6-12 months. Aberration has got played out.
• Don’t fall for credit funds or portfolios with very high AA & below papers for temptation of extra 100 bps of return
• Gilt or long-end play is tempting but very risky with much higher volatility and, in our view, avoidable given that no one can predict when the rate cycle will turn.
• Corporate Deposits are good instruments but over-allocation can lock-in your funds and lead to potential re-investment risk.

Finally, our key point which we wish to make in this note is that Debt is an avenue to preserve wealth, balance with stability in a portfolio where equity investments have been made for growth and make positive real returns to counter inflation. Debt is not a wealth creation instrument and any attempt to do so is fraught with fallacies or unknown unknowns!