Go for high quality and low-to-medium-duration funds in your debt portfolio
With the finance minister sticking to the fiscal deficit target of 3.5 per cent of gross domestic product (GDP) for 2016-17, the market expects rate cuts. Experts, however, suggest small investors be conservative in their debt fund investments.
Interest rate outlook
Debt fund managers think the Reserve Bank governor might at best go for one rate cut in April. Suyash Choudhary, head of fixed income, IDFC Mutual Fund (MF), offers two reasons. One, the cyclical drivers that contributed to low inflation have played out. For instance, cereal prices are growing at two per cent, vegetable prices at five per cent, and rural wages at three per cent.
"Further disinflation on account of these factors looks extremely difficult. Here onward, the next phase of disinflation will be driven by structural reforms," he says.
Since the government has stuck to the fiscal deficit target of 3.5 per cent, RBI seems likely to oblige with one cut of 25 basis points (bps). According to Murthy Nagarajan, head of fixed income at Quantum MF, "After one rate cut, whether you get another will depend on a host of factors - the monsoon, oil prices, global economy, (US) Fed action and so on."
| Time to be conservative |
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RBI might cut rates by 25 basis points and then pause Bond market yields might not soften much due to excessive supply of paper More credit downgrades and defaults could happen Avoid excessive credit and duration risk The average maturity of debt fund portfolios should not exceed five years Avoid credit opportunity funds Stick to safe triple-A and G-Sec portfolios Avoid high-yield FMPs Tax-free bonds an attractive option in the hold-to-maturity portion of a portfolio |
Currency-related issues might also prevent the Reserve Bank of India (RBI) from cutting beyond 25 bps. "A spike in risk aversion, leading to fund outflows from emerging markets, might constrain RBI from easing further when it is trying to contain the rupee's fall," says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.
High supply of paper could also prevent yields from softening too much in the bond market. With the government tapping into every possible savings pool to fund its expenditure need, supply of bonds exceeds demand. Some sources of demand, such as Life Insurance Corporation, are now funding railway projects - earlier, they'd have invested in bonds. All these factors might prevent a sharp decline in interest rates.
Credit outlook
Companies like Jindal Steel & Power and Jaiprakash Associates are in the news for the difficulties they're facing in repaying debt. "With credit rating agencies downgrading companies by two notches at one go, we expect more downgrades and defaults in the near future," says Nagarajan.
Debt strategy
When developing a fixed-income portfolio for a particular goal, keep in mind the time horizon and choose products of matching tenure. Divide any long-term fixed income portfolio into three baskets - hold to maturity (HTM), duration and accrual. Make allocations to these baskets based on your risk appetite and whether you contribute to Employees Provident Fund (EPF).
"A service class person who already makes contributions to EPF should make a lower contribution to the HTM basket. A businessman might have a higher contribution," says Dhawan.
Avoid buying high-duration funds for the duration basket. "A duration strategy is unlikely to perform in the year ahead, just as it did not in the year gone by," says Choudhary. Stick to funds whose average maturity does not exceed five years, like short-term bond funds.
"You may also opt for a dynamic bond fund where the fund manager has the freedom to change the average maturity of his portfolio, based on his interest rate view," suggests Dhawan.
Just as you need to avoid taking too much duration risk, you also need to avoid excess credit risk. Credit opportunity funds are best avoided now, given the leveraged balance sheets of companies.
"Opt for funds with high quality portfolios, those that stick to triple-A or G-Sec papers. Avoid funds with lower rated papers," says Nagarajan.
When choosing a debt fund, take into account the record of the fund house and the fund manager in managing both credit and interest rate risk. The fund you pick should have been true to its mandate in the past. When looking at a dynamic bond fund, check whether it has indeed been dynamically managed.
The fund manager should have increased or reduced the average maturity of his portfolio, depending on his view of where interest rates are headed, not kept it static. Pay attention to expense ratio. You don't want a high expense ratio to erode the already low returns from debt funds.
Within the HTM basket, investors could look at fixed deposits, fixed maturity plans (FMPs) and tax-free bonds. Three types of FMPs are currently available: Triple-A; those with 50 per cent allocation each to AA and AAA paper; and high-yield FMPs which invest in double-A and lower quality paper.
According to Manoj Nagpal, chief executive, Outlook Asia Capital, "Investors should choose FMPs on the basis of quality of portfolio, rather than yield." He strongly advises investors against betting on high yield FMPs for the extra 1-1.25 percentage point return, given their higher risks.
Tax-free bonds have emerged as an attractive option for the small investor's HTM basket. The Nabard one, for instance, offered sovereign guarantee and a coupon rate of 7.65 per cent over a 15-year tenure. If rate cuts happen, investors will reap the benefit of capital appreciation in these bonds. Even liquidity is not a big issue. "Bonds worth Rs 5-10 lakh can be easily traded on the stock exchanges," says Nagpal.
Illustration: Uttam Ghosh/Rediff.com
