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“Look for consistency in a debt fund”
Sat, Sep 01, 2012
Source : Team Citrus Interactive

Mahhendra Kumar Jajoo is currently Executive Director and Chief Investment Officer-Fixed Income at Pramerica Asset Managers, India. His educational qualifications include CA, CS and CFA. He was a silver medalist in the ICAI exam. For the first four years of his career, between 1991 and 1994, Jajoo worked for the merchant banking division of ICICI Bank. In 1994, when ICICI Securities was started, he shifted to debt. He also had a stint in primary dealership at ABN Amro before joining the mutual fund industry.

In this interview with Shoaib Zaman and Jeni Shukla, he spoke on asset allocation, how retail investors should go about building a debt portfolio, and the key factors that they should take into account while selecting debt funds.

 

How has the debt market in India changed over the years that you have been associated with it?

I spent my initial years in merchant banking. In early 1994, I moved to the debt side when ICICI Securities formed a joint venture with JP Morgan. I have always found the debt market more exciting.

In the Indian mutual fund industry debt is still not the most exciting part of the business. But abroad everywhere the debt market is much bigger than the equity market. Globally, for most firms fixed income forms a major part of the revenue.

In India the fixed-income market is picking up. But currently we do not have much depth or a large range of products. Now gradually the assets under management on the debt side are increasing. A large number of new investors are coming in. One has to bear in mind that the mutual fund industry in India is only 15-20 years old.

We had the mother of all bull runs from 2004 to early 2008. But before and after this period things have been very different. So now investors are beginning to think of asset allocation. They have even realised that equity and debt are not the only two asset classes. Gold has outperformed both over the last few years. This shows that investors’ understanding of the investment market is improving. I think we are going to see challenging and exciting times in the debt market in future.

What should a retail investor's debt allocation be?

There is no one answer to this question because various factors are involved in making this decision. 

One, how much you allocate to debt depends upon your stage in life. If you are 24 years old then perhaps you may not have any debt requirement. But if you are 50 years old then you need a less volatile portfolio. 

Next, your risk profile has to be taken into consideration. Let's say that somebody has zero capital base. Such a person may not be able to stomach a loss. He might also need income from his savings. Hence such a person may not invest in equities at all. On the other hand, if someone comes from a well-to-do family, then he can start with 100 per cent equity or another risky asset. So how much you allocate to debt will also depend on your ability to take risk.

The third factor is your willingness to take risk. A person may not have the ability to stomach the volatility in equity markets or he may want fixed returns. For such a person debt investments are a better option.

Apart from these, how much you allocate to debt will also depend on your goals, such as children's education and marriage. This factor can also be clubbed with risk-taking ability. For example, if I'm looking for money for my child's college education four years down the line, then I cannot assume too much risk.

So there can be no one answer to how much an investor should allocate to debt. But as a rule of thumb you should increase your exposure to debt as your age increases. 

Retail investors have a belief that they cannot lose money in debt investments. What would your reaction to such notions be?

This is due to lack of awareness. It is untrue to say that you cannot lose money in debt. It depends upon what kind of instrument you have invested in.

Many people lost money in fixed deposits of non-banking finance companies (NBFCs) in 1994. Many of those NBFCs do not exist anymore. But even at that time people who had put their money in, say, ITC Classic, made money. They did not lose their deposit because it was taken over by ICICI Bank. So much depends on the kind of company you invest in.

The positive aspect of investing in debt is that you enjoy predictability of income. The return profile of this investment is much more certain and less volatile than that of other asset classes. The term fixed-income conveys that your income will be less volatile. But that is at the base. Much depends on the product and on the credit risk you take.

The total return that you get from debt investments will consist of multiple elements. First is the risk-free rate. The second portion is the yield curve, or what we refer to as the investment horizon. The classic wisdom is that the longer a bond's maturity, the higher will its return and also its risk be. For example, a 10-year bond normally gives higher returns and is more risky than a five-year bond.

It is also important that the tenure of the bonds you buy should be aligned to your investment horizon. This will increase the certainty of returns.

On one end of the risk spectrum you have fixed deposits. If the bank survives, then at the end of tenure you will get the sum that has been promised to you. (In the context of European banks today, we don't know if the bank will survive.) At the other end of the risk spectrum, you have open-ended dynamic bond funds where there is huge volatility. Depending on how the market behaves, you could get a 12 per cent return or a 9 per cent return at the end of the tenure.

So what you're saying is that depending upon his goal and his time horizon, an investor should pick a security with a similar duration.

That is precisely what people have done historically. If you look at insurance schemes, they are very popular because of the certainty they provide. Now the markets are changing so people have more options. Historically you picked up a product that was suited to your maturity needs.

Within debt funds there are so many options for investors. How would you recommend a retail investor should go about building this portion of his portfolio?

Basically there are three categories of debt funds: liquid or ultra short-term, short-term income category, and then income fund or dynamic bond category. . Then there is a fourth category that has a component of equity in it. 

A retail investor who is a salaried person will typically have incremental investments to make every month. First, he should transfer all the extra money in his savings account into a liquid fund for better returns.

Next, the investor should do a realistic assessment of his needs and then choose appropriate debt funds. For example, if you have a reasonably long investment horizon and a reasonable risk appetite, then about 50-60 per cent of your investment should be in short-term income plans. About 20-25 per cent should be in dynamic bond funds and another 10-15 per cent in monthly income plans. The balance 10 per cent should be in liquid funds. As the investor gets his monthly income, he should keep adding to these plans.

The investor should choose the growth option over the dividend option. If his investment horizon is of more than one year, then there could be a substantial difference in the total returns he earns depending on the option that he chooses.

First and foremost, risk profiling and a realistic assessment of the investor’s needs should be done. Only then should the portfolio be prepared.

How would you classify the funds called credit opportunities funds? Do they constitute a separate category?

Right now there's a lot of overlap in the debt market between funds, say, for instance, between a dynamic bond fund and an income fund. In my view, credit opportunities fund is emerging as a distinct category.

In our case, we have clearly defined what a credit opportunities fund is. So there is no confusion regarding how the portfolio of a credit opportunities fund should look vis-a-vis that of an income fund. The key feature of a credit opportunities fund is that there are times when you get very good credit spreads and there are times when you get lousy credit spreads. People have to be very clear about when they should enter these funds.

The second thing about credit opportunities funds is that right now the corporate bond market is not very liquid. Beyond AAA there is absolutely no liquidity in most papers. So it is difficult to consistently keep recalibrating the credit opportunity portfolio. The basic objective is to derive higher accrual income because of good credit spread. Credit spread is also volatile. A couple of years ago interest rates were very high, there was liquidity tightening and squeeze on credit availability. Therefore, a number of good companies were available at a very good credit spread. Now today that may not be correct and it may be even less correct in the next six months if liquidity improves. So you have to see whether the positioning of the portfolio is good. 

What is your outlook on interest rates?

Clearly interest rates are stabilising. Three months ago we thought that short-term interest rates would come down. They have already come down. Today we are in an environment where there is a lot of uncertainty.

First, one positive aspect is that inflation by and large is range bound. In my view, it is not a problem if inflation is 7.5-8 per cent. Rather the problem begins if the trajectory of inflation or inflationary expectation is not clear. Today uncertainty regarding inflation is much less. We know with a certain amount of certainty what the inflation range will be. The global environment is also supportive as every central bank is trying to promote growth. The other positives are that commodity prices are coming down and India's current account deficit is stabilising, so the rupee has also found support at current levels.

The negative is that inflation is still very sticky. Moreover, the supply of government debt paper is very huge and the ability of the system to absorb that kind of supply is limited. A bigger problem is that even next year supply is not going to get reduced.

So from time to time the market will swing from positive to negative. Hence you can expect volatility in interest rates around the base rate of 8 per cent. I think it is clear that the short end of the interest-rate curve will be driven by liquidity. We expect liquidity to improve. Short-term rates have already fallen and will remain stable hereafter. Long-term interest rates will remain volatile.

The products that suit the current market scenario include short-term income funds and dynamic bond funds.

Should investors take into account factors like fund size and expense ratio while choosing a debt fund?

From an investor's perspective the size of a fund should not make any difference. We see all kinds of situations – a large fund perform in a particular interest-rate environment and a small fund do well in another environment. Similarly, in the case of expense ratio, we have seen funds with low expense ratio perform poorly and funds with high expense ratio perform well.

So I think the investor or the fund advisor should focus more on the overall track record of the fund house and its fund managers. Check for consistency of performance, the fund’s track record in different market environments, and its ability to navigate different cycles. These are the more important issues. If you focus on them, then I don't think expense ratio or the fund’s size should be a matter of concern.

Obviously size matters in a case where the size is declining and the performance is also on a downward trajectory. But that scenario is different from one where a fund is doing well but the size is small. My personal view is that expense ratio does not matter as it is more important to see what returns the fund has delivered to the investor.

The basic value proposition is: what is the current interest rate, what do people expect, and are this fund's papers relevant to the current environment? Second, you should check the fund house’s track record. The third thing to look for is consistency in a fund. The fourth is to examine the fund's level of disclosure and whether it sticks to its stated objective. These are the things that matter.

How should an investor judge the quality of information made available by fund houses? In any case, most fund houses have a policy of quarterly disclosure and only some AMCs allow their fund managers to share their views.

Compared to other options, the level of disclosure in mutual funds is very high. Portfolios are disclosed every month and fund houses do share their views regularly.

How should investors who have a one- and a three-year investment horizon invest in debt funds?

In case of a three-year horizon, 60 per cent of the debt portion should be invested in dynamic bond funds and the rest in a combination income funds and short-term bond funds. For a one-year investment horizon, the investor should invest in short term income funds and dynamic bond funds. At times, even fixed maturity plans (FMP) could be a sound option. 

 
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