Q . Can be share how the new risk category defined by SEBI will be applicable for debt funds? What has changed now for risk rating the debt funds?

Answer : Risk Score will be considered by taking the simple average of 1) Credit Risk of Debt Securities,
2) Interest Rate Risk of portfolio and
3) Liquidity Risk Value
Credit Risk Score will vary from 1 to 12
For eg., 1 for Gsec / AAA and 12 for Unrated Securities
Interest Rate Risk Score will vary from 1 to 6
For eg., 1 for Portfolio Macaulay Duration <= 0.5 and 6 for > 4
Liquidity Risk Score will vary from 1 to 14
Listing status, credit rating and structure of debt instruments considered
For eg., Treps/G-Sec/AAA rated PSU/SDL will have a score of 1
AAA rated debt securities with any of the features: Unlisted, bespoke structure, structured obligation, credit enhancement, embedded options will have a score of 3
Below investment grade / unrated debt securities will have a score of 14
If Liquidity Risk score is higher than the average of Credit Risk, Interest Rate Risk and Liquidity Risk, then Liquidity Risk Score shall be the Risk Value of the Fund
Now what has changed

Q . Given the fear of an economic slowdown, expectations are that the interest rates will remain low for some time to come. In such a scenario, what should the investor return expectations be from short, medium and long duration debt funds?

Answer: In the current scenario rates are expected to stay low over medium term. Surplus liquidity, accommodative stance and RBI unconventional measures have created a perfect environment for benign rates and steep curves. Currently tenor spreads across asset classes are quite attractive. With RBI supportive measures we might see some flattening in yield curves across asset classes. Investors will also stand to benefit from the present curve steepness which provides protection while adding duration. Investors with a longer investment horizon can add duration to their portfolio to encash the attractive tenor spreads. From a short to medium term perspective they can focus on a good blend of accrual income and duration.

Q . In layman terms, what is the risk today in investing in debt funds and what should investors do to manage the same?

Answer : Extremely uncertain times are posing major risk to any investment decision. On the pandemic front, the world still continues to fly blind with fundamental upside & downside risks to the outlook of every macro-economic variable. Globally as well, fear of second wave of infections, no certitude around vaccine timelines & efficacy, geopolitics, US election induced turmoil are relentlessly battering financial markets. For debt funds in particular, if inflation print fails to fall within RBI’s comfort zone, the central bank will be forced to act. Although possibility of unwinding of liquidity measures in near term looks dismal, it cannot be completely ruled out. Any policy reversal signals will lead to hardening of yields. Market might also remain choppy due to volatility induced by external events.

Nevertheless, if the investor has matched his investment horizon with duration of the debt fund, his returns over the investment time frame are protected. Further, investors can explore roll down funds that offer good visibility of returns amidst the current uncertain scenario. Also the duration risk proportionately reduces in case of roll down funds as time progresses, thereby protecting investor returns. In current times, investors must prioritize funds that focus on maintaining good credit quality assets in their portfolio. Further, funds leveraging the current attractive tenor spreads to generate excess returns should be prioritized. This is extremely important because extant curve steepness and compounding offer protection while taking duration risk in such funds.

Q . How are your managing your portfolios of flag-ship funds? Can you share your underlying views on macro-economic front guiding the portfolio construction?

Answer : We continue to believe that there will be some element of near-term uncertainty around inflation which will progressively ebb as supply pressures begin to ameliorate. RBI has clearly stated that it will look through inflation induced by supply side factors. However, over medium term the economy is headed towards a low growth, low inflation environment. Thus, there is a strong case for interest rates to remain anchored at benign levels over medium term on account of supportive RBI measures and fundamental factors like low inflation-low growth dynamics. The focus of monetary policy will clearly continue to be on revival of growth in a durable way which in turn is bound to be sluggish. The interest rate outlook might stand punctured if there is some interim volatility induced by external events.

Going forward, RBI will also be proactive in orderly management of demand-supply dynamics of bond market and hence sovereign borrowing program will sail through smoothly. Possibility of further rate cuts appears bleak; however unconventional support will persist. Thus going ahead Gsec yields would remain range bound.

Keeping the dynamic of a benign interest rate environment with intermittent volatility, the portfolios will be aligned such that core allocation continues to reflect our view that interest rates would remain range bound, but the tactical allocation remains nimble to interim market volatility. However, amidst such highly uncertain times it will be prudent to reduce the tactical component of portfolio allocation in order to limit the value at risk during unfavourable interest rate movement.

Q . What advantages do debt funds offer over say bank FDs in the current phase of low returns from debt funds? What would be your advice to investors looking for debt investments at this point of time?

Answer : Debt funds with a good blend of accrual income and duration are expected to outperform bank FDs in medium to long term. Secondly, in active fund management tenor spreads (curve steepness), selection of assets, tactical duration calls etc. can be effectively leveraged to generate excess returns.

Further debt funds offer easy liquidity over bank FDs. On a post-tax basis debt funds stand to outperform bank FDs.