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Investing in bond funds : What you actually need to know, by Dheeraj Singh

This is a guest post by Dheeraj Singh. Dheeraj was a fund manager for many years specializing in fixed income. He used to head fixed income at IL&FS Mutual Fund (before it got taken over by UTI) and subsequently worked with Sundaram BNP Paribas Mutual Fund (now Sundaram Mutual Fund) heading the fixed income desk. He runs Finanzlab Advisors, a treasury and risk management consultancy.

(Warning : Slightly long read, but probably worth it)

For the past week and a couple of days more investors in debt funds (of any flavor) have had a tough time.

RBI’s actions to constrain money market liquidity, in it’s attempt to arrest the fall in the value of the rupee in the foreign exchange markets, has led to a blood bath in the bond and money markets with yields rising sharply (equivalent to prices falling).

(Read: RBI has had two moves to constrain liquidity: One, Two)

Price movements have been large enough to ensure that even liquid funds could not ignore market prices in their valuations. Liquid fund net asset values are generally expected to grow by small amounts every day (by ignoring actual price changes). However that is true only if actual price movements in the market are small. In case of large price movements (generally greater than 0.1% on a portfolio basis) actual price movements have to be factored in.

Hardly had the market recovered from the initial RBI move announced late into the night on July 15, that we had some follow up measures on July 23, which exacerbated an already bad situation.

Consequently even liquid funds have generated negative day on day returns at least on two occasions within the last 10 days (as on July 25, 2013).

These developments have led to apprehensions in the minds of investors, several of them unfounded.

I have come across people labeling debt fund managers as incompetent. Nothing could be farther from the truth. Debt fund managers perform a very difficult task, that of managing the portfolio which is marked to market on a daily basis, within an uncertain and volatile environment. They do manage risks but that can be done only within the parameters of what is known and what can be anticipated. Unanticipated events like the RBI action are, by definition, impossible to protect against. Of course, there will always be some managers who are more skillful than the others. This doesn’t mean that we paint the entire community of debt fund managers with the brush of incompetence.

So, given the experience of the past few days, how should investors evaluate fixed income or debt mutual fund investments. It is no easy task, but some of the pointers below may enable investors to make a more informed decision

1. Appreciate the market linked nature of returns :

Returns from debt mutual funds come from two sources

i) the regular coupon accruals; and

ii) the gain or loss that arises due to fluctuation in market prices

Unless there are credit defaults, the coupon accrues regularly every day, usually at a fixed rate – this provides the regular daily return to investors in the fund as long as market prices do not change.

The situation becomes complicated however, as market prices are rarely constant. When prices go up, the return gets enhanced, and when they go down they take away from the regular accruals. When the price fall is large, the regular coupon can be completely wiped out by the extent of the price fall.

To get a view of the relative weightages of the two components in the total return, let’s consider a single security portfolio which has a coupon rate of 10% per annum. In such a case, the daily coupon accrual per Rs. 100 of investment can be calculated as

Daily Coupon Accrual =  0.10 * 100 / 365 = 0.0274

In other words the daily coupon accruals add a little less than 3 paise per Rs. 100 of investment. This corresponds to a return of 10% per annum.

In contrast, price changes on a day can sometimes be as large as 20 to 30 paise per Rs. 100 in case of very short term securities and as much as Rs. 2.00 to Rs. 3.00 in case of medium to long term securities.

When prices rise, they add to that 3 paise of coupon accruals. When they fall they take away from those accruals.

In effect, the returns are extremely sensitive to price changes in the market place.

This is what makes the return from these products attractive at times and unattractive at other times.

In the case of liquid funds which generally invest in securities maturing in 60 days or less, prices changes of upto 10 paise (approx.) are allowed to be ignored. Without this rule, returns from liquid funds would also suffer from volatility and the whole purpose of using liquid fund as a stable short term investment would be defeated.

However, when price changes are more than 10 paise, funds have no choice but to take on record these price changes and value the underlying securities accordingly. This is done to ensure that the valuation of securities in the portfolio does not deviate too much from the true market value. This is important since, if valuations are not close to market value, the fund returns would suffer volatility if and when the manager actually sells the security in the market.

The negative returns witnessed in liquid funds on a couple of occasions in the past few days was precisely for this reason (of valuing securities at their correct market prices). Prices fell by more than 10 paise and funds were forced to take on the actual market prices to value their portfolios.

This could as well have worked the other way. Had prices risen, returns from the funds would have been abnormally high. This kind of situation too occurs from time to time in the market, but since that’s generally good news for investors it gets ignored. Bad news commands a greater audience.

The revaluing of the portfolio of securities is actually a good thing for many reasons :

1) It is fair to new investors

While existing investors suffer, the revaluation of a portfolio provides new investors with an opportunity to invest and earn a fair market related return. Without revaluation new investors would suffer and existing investors would benefit. New investors would end up subsidizing existing investors. I’m sure none of us would like to be in such a situation.

This phenomenon can already be witnessed with liquid funds. Prior to July 15 liquid fund returns averaged about 8.0-8.5% per annum. After the fall in prices on July 16, returns started averaging about 10.0-10.5% per annum. This reflected the fact that yields in the money market had gone up by about 2% per annum. For new investors this provided an entry point to earn the higher return. If funds had not revalued (to avoid that negative one day return), new investors would still earn only 8-8.5% per annum.

This is a fundamental principle of any market mechanism and we should recognize it’s utility and fairness.

2) Interest rates do not rise (bond prices do not fall) indefinitely:

Unless we really manage to screw our economy very badly, interest rates generally move in cycles, meaning if they’re on the way up, they’re more than likely to reverse and start moving down. Conversely, if they’ve been moving down, they’re more likely to start moving up in the near future.

What this means is that, unlike equities, bond investments do not, generally, suffer from the “catching a falling knife” metaphor.

(Assumption : We’re considering only credit default free bonds. Prices of bonds issued by entities which default can fall continuously and even be worth nothing.)

 

3) Bond price movements actually become less sensitive at higher interest rates

Bond prices are most sensitive when interest rates are low – meaning, price changes can be large for even small changes in interest rates. However once interest rates have risen, this sensitivity goes down.

Price changes are larger when interest rates are low and smaller when interest rates are high.

This is better understood visually. The chart below depicts the price behaviour of a typical bond for different levels of yield.

clip_image004

(This is the general shape of the price yield curve of all option free bonds. The curve is downward sloping convex to the origin. While some bonds will display a more convex shape others may show a lesser convex shape. Higher convexity is a desirable feature in bonds).

Looking at the graph one can infer that prices movements are larger (P1 to P2) even for small yield changes (Y1 to Y2) when the absolute yield levels are low. Price changes are smaller (P3 to P4) even for a larger change in yield (Y3 to Y4) at higher levels of yield.

Effectively, once you invest at higher interest rates, the price risk that you take is much lower compared to the price risk that you take when you invest at lower interest rates, even if the portfolio of bonds remain identical.

This alone should dispel any doubts about investing in bonds or bond funds when yields have risen sharply and are likely to remain high only for a relatively short period of time. Conversely, if yields have fallen and are unlikely to sustain the fall, that is the time to start getting worried about your bond or bond fund investments.

The reality is when yields fall the positive price changes inflate our return. This manifests in complacency at the very time that caution is advisable. On the other hand, when yields have risen and are likely to fall sometime in the near future, it is possibly the best time to invest in bonds and bond funds with greater enthusiasm.

Disclosure : I have been a senior professional of the fund industry in the past. To that extent, some bias may creep into my writing. Also, I may possess information of and about the industry that may not be generally known. This could have a bearing on how and what I write.

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  • Shiva says:

    Nicely explained! I have one doubt regarding the capital loss. This loss is taken by an investor only if he redeems his units on the eve of the crisis, right? Cause if one holds the bond till maturity then he would be getting the face value of the bond. So theoretically any liquid fund/debt fund investor should not be having capital loss if he holds his units for a significant time(during which the fund moves towards the face value of the bonds) after the crisis day. Am I missing something here?

    • Dheeraj says:

      What you say is true for a special class of funds called “Fixed Maturity Plans” or FMPs. These are funds which mature on a predetermined date and invest in securities which mature on or around that date. Further, entry into the fund is allowed only during the initial offer period. No entry or exit is allowed subsequently. This allows the fund manager to match the maturity of assets to the maturity of the fund. Intermediate price fluctuations can therefore be ignored.
      In case of normal open ended funds, investors enter and exit the fund on a daily basis. This entry and exit takes place at a price that is linked to the Net Asset Value. One cannot therefore ignore price fluctuations even if you hold on to the units for long periods. Yes, over a longer time frame the returns would tend to even out (as I have explained in the paragraph which talks of the “falling knife” metaphor). In the interim however, there will be periods of, possibly, alternating high and low returns. For short term investors timing of entry and exit therefore becomes important.
      Long term investors can reasonably safely ignore timing of entry and exit. But sometimes even they can be caught on the back foot. Investors who held the units of bond funds and exited on July 15, 2013 would have been far better off than investors who held on. There could also be situations where conditions are the opposite.
      That said, contrary to what many people say, debt funds (as a category) have in general been better performers than bank deposits. This better performance comes with the added benefits of significantly greater liquidity, perfect transparency (when was the last time a bank told you where your money is put to use?) and fair pricing.

      • Gold Bug says:

        Not convinced by yourexplanation. All Bonds funds including income funds have mandate to move from Bonds to Cash. If alert fund managers could read taper talk of Bernanke on 21st May they could have moved significant amount to cash before or even as FIIs were exiting Emerging Markets world wide and also Junk Bonds in US. The signs were clear. Is it not a question of competency?

        • There were no debt problems after the taper talks. Yields didn’t rise substantially – probably just 20 bps, and that too at the long end, the short end remained around 7.50%. Going to cash would have caused problems, not solved anything.
          The particular “crash” was because of RBI squeezing liquidity which was unexpected by nearly everyone because RBI has shown ZERO desire for it, and equivalent to raising rates in a rate cut cycle that just began this year (and cycles are typically multi-year). If someone had any knowledge on the day, it’s unlikely they could dump a large portfolio in such a short time.
          Thirdly, there’s nothing wrong with bonds, this is the way the market is supposed to be. I’ve written about this in the past – bond funds have risk. If you ignore that, obviously bond funds are perilous. I own short term debt funds. They have been hit. I don’t need much money now, so I’ll stick around – for me it’s just a minor cut in profits. (I’ve been in since 2011. Have made more than 20% absolute. The current hit takes me back by one month, but it is only a TINY blip in an very profitable investment.

        • Dheeraj says:

          Agree with Deepak.
          Also, on competency let me make a statement.
          Bond Fund managers in India function in an extremely difficult environment. Illiquid markets, unreasonable client demands, strict regulatory compliance and exacting service standards.
          I’ve been one (when times were even more difficult), so I know.
          And how I wish markets behaved as simplistically as you have described. Most often, they do not.
          Much like a doctor cannot prevent death or serious illness or a lawyer cannot prevent conviction, a fund manager cannot always produce absolute positive results.
          The day media stops glamorising fund managers and treat them as a professional performing a particular role, the better it would be for all.

  • Gold Bug says:

    The current hit has taken my debt potfolio back to mid April with mix of various maturities. Now I have been forced to become long term investor. To compensate I had to buy highly risky DSP BR World Gold Fund with a hope that in one year I will get even after indexation.

    • Why would you compensate for the risk in a debt investment by a world gold fund, an even more risky investment? 🙂
      This going back to APril thing must involve longer maturities. The longest my funds have gone back to is June end. If you owned longer duration bonds, you owned much more risky assets…

    • Dheeraj says:

      Yup. You are truly playing with fire here.
      Trying to recover losses from a risky investment by getting into a riskier investment.
      By investing in the World Gold Fund, not only are you taking a risk on gold prices you are also taking on exchange rate risk.
      Your handle seems to suggest you’re already into gold, so I presume you know what you’re getting into. Wish you all the best.

  • Hi, A number of liquid funds add FDs of 3M and keeps rolling. Wish to know how is FD valued in liquid funds?

  • Okay. Debt valuation norms which I found on a website says “FDs will be valued at cost plus accrual (Rate given) less prepayment penalty if any”…If this is the case then probably funds holding FDs may lag in terms of return when CD/CPs have rose more than ~180-200bps..Am I correct?

  • Siddharth says:

    Hi Deepak,
    Can you tell me if there are MFs for individuals to invest in corporate bonds and if there is a structure in place to invest in a definite set of bonds based on rating. For eg., are there Mutual funds targeting only AA bonds or if we can choose MFs having a portfolio of bonds having a mix of one or more ratings. ?
    If so, kindly let me know the.
    Regards,
    Siddharth V