Why are my debt fund returns volatile these days?

Given the backdrop of frequent defaults and downgrades in several credit risk oriented funds over the last one year, it is natural to be concerned about the recent volatility in debt funds.

Before you paint every fund with the same brush, let us understand the context behind the current volatility.

There are two legitimate risks that any debt mutual fund can take to enhance returns.

Credit Risk

There are certain debt funds which lend your money to lower rated corporates in return for higher yields (read as the interest rate paid by corporates for borrowing money from the fund).

As long as the underlying corporates fully service and repay their debts on time, these funds enjoy higher returns compared to higher credit quality debt funds (who lend predominantly to AAA rated corporates, financial institutions and government).

We have been avoiding such credit risk oriented funds in recent times, given the weak economic backdrop and the increasing risk of redemption pressure (investors selling out of the fund).

As lower rated papers cannot be sold easily given the illiquid market for these securities, whenever there is a surge in redemptions from these funds, the fund manager is forced to sell other higher quality papers (which can be sold easily) in the portfolio. This usually leads to unintended higher concentration of lower quality papers in the fund significantly increasing the risks.

Due to Covid-19 led concerns, we have noticed that several credit risk oriented funds are witnessing a sharp increase in redemptions. Unfortunately, this is a risk that is not under the control of the fund manager and is difficult to manage.

In our view, this makes credit risk oriented strategies extremely risky at this juncture.

All our recommended funds at the current juncture are proven funds with high credit quality (predominantly AAA & equivalent exposure) and we continue to avoid credit risk strategies.

With credit risk out of the way, you must be wondering as to why your debt funds returns are still showing higher volatility (with a few intermittent days of decline) in recent times.

This is due to the second legitimate risk that debt funds take called Interest Rate risk.

Interest Rate Risk

Let me explain this with a simple example.

Assume you have opened a Fixed Deposit for Rs 1 lakh at 6%, this will give you Rs 1,06,000 after 1 year.

What if suddenly the bank increases its interest rate from 6% to 7% the next day?

This means, you got unlucky as could have invested a lower amount Rs 99,065 (vs the original Rs 1 lakh) to get the same 1,06,000 after a year.

What if instead, the bank reduces its interest rate from 6% to 5%?

In this case you got lucky as otherwise you should have invested more i.e Rs 1,00,952 (vs the original 1 lakh) to get the same 1,06,000 after a year!

In the real world, FDs are not tradable. But hypothetically if you assume you could trade your FDs everyday, this implies the price of your FD will change if interest rates move up or down.

As seen above, if they move up, then your FD (already locked at lower interest rates) becomes less valuable and hence the trading price of your FD would come down to adjust for the new higher interest rates. Similarly, if interest rates move down, then your FD (already locked at higher interest rates) becomes more valuable and hence the trading price of your FD would go up to adjust for the lower interest rates.

This is exactly what happens in a debt fund which invests in bonds which are traded every day and the price of the underlying bonds fluctuates everyday based on change in bond yields.

If interest rates move up then your debt fund NAVs have a negative return impact and vice versa.

However the extent of the same interest rate movement in your debt fund NAVs will depend on a parameter called modified duration.

Modified duration is measured in years and tells us what would be the expected increase or decrease in fund NAV for a 1% change in interest rates.

Change in fund NAV = (-1) X change in interest rates X modified duration

Assuming that a fund’s modified duration is 2 years and the yields rise by 0.5% then the fund’s NAV should drop by 1% (calculated with the above formula: (-1) x 0.5% x 2).

So higher the modified duration for a fund, higher the interest rate sensitivity.

Why are debt fund returns volatile in recent times?

In the month of Mar-20, there was a sharp spike in yields across the short term segment leading to temporary decline in NAVs across several debt funds.

This was due to

1. Foreign Investors selling out of Indian debt markets – Flight to safety from emerging markets
2. Redemption pressure from Domestic Institutional Investors – Significant redemption pressure led by advance tax requirements, hoarding cash for near term payments and investors redeeming due to Covid-19 concerns

On 27-Mar-20 the RBI had come out with several announcements, to address the liquidity concerns and post that most funds recovered their previous NAV decline.

However, the last few weeks have again been witnessing some volatility, due to continuing foreign investor outflows and redemption pressure in mutual funds.

We think this is a temporary phenomenon and expect yields to come down especially in the shorter duration segments.

Why do we expect yields to come down?

• RBI maintains ‘Accommodative’ stance: RBI mentioned that it would maintain accommodative monetary policy for as long as necessary to revive growth and mitigate the impact of COVID-19 while ensuring that inflation remains within the target.
• Inflation to moderate: We expect moderation in CPI in the coming months led by falling crude oil prices, lower food prices, and weaker consumer demand due to the spread of COVID-19. CPI inflation for Mar-20 declined by 70 basis points to 5.9 per cent. RBI’s outlook has indicated inflation to fall below 4% by the second half of FY21. Such an outlook provides further policy space to address the intensification of risks to growth and financial stability brought on by COVID-19.
• Current Yields yet to completely reflect the rate reductions of RBI
• Significant Liquidity injection measures: The three measures relating to TLTRO (Targeted Long Term Repo Operations), CRR and MSF will inject total liquidity of Rs 3.7 lakh crs into the system.
• LTRO (Long Term Repo Operation) and its Impact:  Banks are offered 3-year money at repo rate of 4.4% under LTRO. The total allocation of Rs.1 lakh crore has been auctioned by RBI. The LTRO funds have to be compulsorily used by banks for bond purchases – 50% each in primary issuances and secondary market purchases. Banks need to hold these securities in held to maturity (HTM) category. Currently only a fraction of the money has got deployed so far as banks need to procure board approvals which typically takes 1-2 weeks. Work from home and curtailed market timings causing some delay. This creates huge upcoming demand for corporate bonds. Once banks start deploying the funds, spreads are likely to drop sharply for AAA companies followed later by lower rated companies.
• Surplus liquidity: Banks are still keeping significant money (~Rs 6.9 lakh crs as on 14-Apr-20) with RBI under reverse repo rate of 4% (further reduced to 3.75% to discourage this) indicating that banks have enough money but are very risk averse and not lending to corporate and individuals.
• Global Monetary Stimulus and Easing: Most of the major central banks have taken aggressive measures to provide monetary stimulus and have reduced interest rates. We are heading into a low interest rate environment globally.
• RBI has announced further measures on 17-Apr-20:

1. Reverse repo rate cut by 25 basis points to 3.75%: To discourage the banks to not park their money with the central bank (currently around ~Rs 6.9 lakh crs) and instead lend more to corporate and individuals.
2. Targeted Long Term Repo Operations (TLTRO) 2.0: For easing credit to NBFCs. Rs 50,000 crs to be invested by banks into investment grade bonds, commercial paper, non-convertible debentures of NBFCs with at least 50% of it going to small and mid-sized NBFCs and micro finance institutions (MFIs).

• Possibility of further RBI measures and rate cuts: Expect few more rounds of rate reductions and much bigger quantum of liquidity infusion – OMO and LTRO of much larger quantum.

Summing it up

As per RBI Governor’s latest assessment, in response to these TLTRO auctions, the financial conditions have eased considerably, as reflected in the spreads on money and bond market instruments. Moreover, activity in the corporate bond market has picked up appreciably, with several corporates making new issuances. There are also indications that redemption pressures faced by mutual funds have moderated.

Given the above context, we recommend investors with fresh money, to invest immediately before the yields start to decline.

For existing investors, the expected fall in yields can provide a return kicker (extent will depend on the duration of the fund) compensating for the recent decline in NAV. So while the volatility may continue for the near term depending on when FII outflows and domestic redemptions stabilize, staying invested without panicking through this period can lead to meaningful positive returns when the yields start to decline.

That being said, it is preferable to avoid credit risk oriented funds (despite the higher yields) given the current stressed credit environment.

Overall, we continue to remain positive on all our recommended debt products and prefer high quality short term strategies at this juncture.