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.
(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.