Saturday, March 16, 2013

Three debt fund ideas as an alternative to company and bank fixed deposits


Introduction

The current CPI inflation is at 10.91% as on Feb 2013 end. So we must be making at least around 12% p.a. after taxes and other charges on our principal amount to ensure inflation isn't reducing our purchasing power.

If you have been hunting for a good bank FD that pays better than the current CPI, you will be hard pressed to find it. Most highly rated banks are offering only around 9% with some offering upto 9.25% which after taxes if you are in the highest tax bracket comes closer to 6%. This means your money is actually losing its purchasing power if left in bank fixed deposits.

If most analysts are to be believed it is only going to get worse this year with interest rates headed down (because apparently according to one analyst RBI mostly looks at something called as "core inflation" to determine rate revisions and that is hovering around 3.8% as on Feb 2013 end). If you are in the 30% tax bracket tax-free bonds are one option but those too have lower coupon rates this year than last year and much below the current CPI inflation.

The other option is bank deposits with lower rung banks which are risky OR company deposits which are probably even more riskier -- both carry a high default risk on both prinicipal and interest. Yet another option is bonds or bond funds. Here we review three bond funds that may be suitable as an alternative.

What are bonds and debt funds?

For the uninitiated, bond funds are mutual funds that take your money and lend it to others. They lend by buying bonds and other money market instruments issued by companies, financial institutions and the government. Bonds are basically I-owe-you notes which the seller of the bond gives to the buyer. Each bond has an interest rate attached to it called a coupon rate which is the interest paid by the bond issuer to the bond buyer. Bonds can be traded in the financial markets. A buyer of a bond can sell it to a third person. In that case, the bond issuer now owes the principal to this third person along with interest payable as mentioned in the bond. Governments, companies etc. raise money for their financing needs by issuing bonds of a certain value with a certain coupon rate. Bond funds primarily invest our money in these bonds taking into account various factors.

Yield: To explain yields, let us take the example of a bond that the Government of India (GoI) has issued that matures in 2022 with a coupon rate of 8.15%. This means the principal will be repaid in 2022 and an interest rate of 8.15% will be paid to the bond holder. In the financial markets this bond is traded by bond funds and other financial institutions. Yield is basically the effective interest that the buyer of this bond will get when purchased at prevailing rates for the bond. The current yield is 7.86% for this bond which means a Rs.100 face value bond is being bought at Rs. 103.6.

How is this arrived at? 
The money you paid was: 103.6
Interest you will receive from the issuer is: 8.15%*100 (face value of the bond) = 8.15
Actual interest rate you earned on your investment = 8.15/103.6 = 7.86.
Thus the effective yield is 7.86% when you buy a 100 rupee bond at 103.6.

Relationship between bond prices and yields

Thus as bond prices increase, the yield comes down and as bond prices go down the yields increase. The demand for bonds increases when the bond has a higher coupon rate than the prevailing interest rates,so falling interest rates will drive up bond prices of higher maturity bonds (because they have a higher coupon rate). The demand for bonds also increases when other asset classes aren't doing so well. Notably in large equity market crashes, it was seen that good quality bonds were in high demand because of the guaranteed returns.

Debt funds

So if you wish to profit from a falling interest rate regime and believe that other asset classes aren't going to give you great returns , then you should be buying bonds now. However, most GoI bonds are not available for purchase by the general public. We could invest in bonds issued by companies, however we are exposing ourselves to higher risk here because normally we will be able to buy only a few companies' bonds and so we are exposed to the risks of those companies doing well enough to pay the interest and principal on time. Besides, we are not experts to determine which company's bonds are better suited for us. Mutual funds come to the rescue here just as in equities.

A debt based mutual fund manager will do the picking for us, so it is safer to invest in a debt based mutual fund. There are several types of debt based mutual funds though, usually classified by the duration of the bonds that they buy. As you may know already, the shorter the duration the lesser the coupon rate, but better the liquidity.

Longer duration bonds better?

So if our premise of interest rates falling this year is true , the second premise of other asset classes not giving us great returns this year is true (we have already seen bank FDs not giving us great returns, the stock markets have run up quite a bit already last year) then bond funds that invest in longer maturity bonds seem like a good choice.

These kind of bond funds are usually classified differently based on the website you use. Here are some names in three popular sites. Intermediate Bonds (Morningstar), Long Term Government Bond (Morningstar), Intermediate Government Bond (Morningstar), Debt:Income (Valueresearch), Debt:Gilt Medium & Long Term (Valueresearch), Debt Long Term (Moneycontrol) and Gilt Long Term(Moneycontrol). The ones with the name Government or Gilt invest primarily in state and central government issued bonds, the other invest in all kinds of bonds including government and company issued ones.

The case for Dynamic bond funds

Within all of these there is a class of bond funds called dynamic bond funds which have an open mandate to invest based on the interest rate cycle. So the mutual fund manager decides when to buy longer maturity bonds and when to buy shorter maturity bonds. In other words, these kind of bond funds are actively managed so even if our premise above is untrue, these managers will still manage to give us a decent return by changing their strategy. Investing in bond funds that can only invest in only one class of bonds (e.g. government securities) and only one type of duration (e.g. longer duration or shorter duration) tend to be riskier if you don't get your timing right. Of course, with higher risk may come higher rewards, but we will tread an optimal path here with dynamic bonds. Basically dynamic bonds are the debt equivalent of a diversified equity fund.

Tax treatment and growth option

Unlike in the case of company deposits and bank FDs where the interest income is charged at your regular tax slab rate, profits from bond funds in the growth option is treated as short-term capital gain or long-term capital gain depending on the time you have held the bond fund. 

The dividend option of bond funds is not advisable because in the 2013 budget the dividend distribution tax is now 25% plus surcharge and cess for debt funds, thus effectively negating any advantage you get by investing in bond funds. The mutual fund will deduct this tax from what dividend it could have paid you.

Factors to consider when buying debt funds

1. Asset quality: Make sure the average credit quality of the bonds that the debt fund buys is mostly Sovereign (Government) or AAA. There will be the odd bond that is a notch below AAA, but the majority should be AAA or Sovereign. This will ensure you get the reliability of a bank FD. Debt funds that buy what are called as junk bonds (lower rated bonds) are prone to higher default risk and thus give poor returns in the longer run.
2. Exit load: Decide on your timeframe for holding the debt fund and see what the exit load for that time frame is. I have assumed a holding period of atleast a year for the funds discussed in this article. If yours is lesser, then you need to consider paying up the exit load as well that will diminish your returns by another percentage point.
3. Manager's time in the fund: Its extremely important that the manager has spent some time managing the fund you are about to purchase. I have considered 2 years as a reasonable time (greater than that is nearly impossible to find in the debt fund market). This is because ultimately you are handing over your money to this manager for safe keeping and generating income out of, so you must give it to someone who you has some history with the fund and a good track record.
4. Quality of the asset management company: Despite point 3 above, managers do leave. Unfortunately, there is no clause that allows you to exit the fund without exit load whenever a manager leaves. So you are now at the mercy of the asset management company (AMC) to pick a new good manager that will replace the earlier one and hope that this manager will be as good or better. The quality of the asset management company thus plays an important role. A good quality AMC will have standarized processes that it follows that will ensure big mistakes are not made by any fund manager. We can only judge the quality of the AMC by seeing what other funds it has in its stable that are also doing well and the past record of the fund when the current manager wasn't managing this fund.
5. Fund ratings: Several sites and rating agencies provide ratings on mutual funds. Three that I look at are Morningstar (Star ratings and qualitative when available), CRISIL (available on moneycontrol) and ValueResearch. These ratings will confirm your own research and also help you quickly filter out poor performing funds.
6. Fund size: Only consider funds with a reasonable size. I have only considered funds that have a fund size of atleast 100 crores. Smaller funds may sometimes provide good performance but because of their size maybe limited in the kind of bonds they can buy , may not receive enough love from the fund manager because of its tiny size and may have high expense ratios.
7. Sortino ratio: Sharpe ratio and sortino ratios are used to calculate the return w.r.t volatility. While the sharpe ratio considers both downward deviation as well as upward deviation, sortino ratio considers only downward deviation. We would prefer a fund that isn't too volatile in its performance while giving us good returns. We would prefer funds that give better returns than average in markets that are going up, but contain the downward deviation when markets are going down. The sortino ratio measures that and a higher sortino ratio is  better.
8. Past performance: Year-To-Date returns (i.e. performance from the beginning of the year till date), 1 year returns and 3 year returns were considered to arrive at the shortlist of funds. This ensures that while they are doing well in the short-term they have also been able to do well in the longer term. This eliminates any flash-in-the-pan performance jumps that some funds see.
9. Expense ratio: What returns a fund makes are after expenses that it incurs. So higher the expenses , the lower the returns for us. Funds with less than 2 as their expense ratio and lower expense ratios among similarly performing funds were preferred. See tip in the conclusion section for getting the same mutual fund at lesser expense ratios.

Three funds you can consider

The three funds that finally made the cut were the following. Of these, if you had to pick two, the first two would be the ones to go with and if it is only one, the first one.

Sl.No.FundExp RatioMorningstar3 yr RatingValueResearch RatingCRISIL RatingFund Size Crs.Manager Since3yr Sortino Ratio
1IDFC Dynamic Bond B1.52%5313855Oct-107.59
2SBI Dynamic Bond1.76%5414373Jan-1110.73
3Birla Sun Life Income Plus0.75%4231185Jan-102.34



Sl.No.FundYTD1 yr returns3 year returnsUpdated On
1IDFC Dynamic Bond B3.52%13.44%10.02%16-Mar-13
2SBI Dynamic Bond2.93%12.18%10.55%16-Mar-13
3Birla Sun Life Income Plus3.15%12.02%8.36%16-Mar-13

Note:
1. The Expense Ratio is the latest expense ratio as published by the AMCs in their respective websites.
2. The returns data, sortino ratio is from Morningstar.
3. The Manager since data is from ValueResearch.
4. In CRISIL ratings, 1 is the best, Morningstar and ValueResearch 5 is the best.

What are the risks?

The risks with investing in debt funds vs. bank fixed deposits is that the returns are not guaranteed. You may even incur losses instead of earning money on it during certain periods (till the fund manager makes corrections hopefully). Debt funds are a middle ground in terms of risk between equity and bank deposits and the returns also usually reflect this middle ground.

Another risk with our premises is that new issues of bonds can dampen bond prices of existing bonds. With GoI announcing an enhanced borrowing program in this budget, bond prices may not go up as much as hoped even with falling interest rates.

However, with these picks judging on past record, these risks seem to be contained.

Conclusion

Dynamic bond debt funds can be a useful addition to one's portfolio when other fixed income instruments and other asset classes aren't delivering good returns. Depending on your personal circumstances, in consultation with your financial adviser you could consider any of these three funds or use a similar methodology to arrive at your own shortlist.

Tip: If you are going to invest in a mutual fund in the future, invest in the Direct version/plan of the mutual fund. You can do this only if you submit you form directly to the AMC online or offline without any broker/distributor in between. This saves you a few points of expense ratio that would have been otherwise paid to the distributor.