Difficulties of managing debt funds in India

We have been asked numerous times as to the reason why we do not have a debt fund with the sole exception of a liquid fund that we run. Even the liquid fund that we run was launched after much foot dragging and on the back of persistent demand from clients and advisor partners.

We do not have a short-term fund, medium term fund, credit risk fund, gilt fund or for that matter even a balanced/hybrid fund.

While we have spoken about the reasons for this in the past in short sound bites, I believe it makes sense to articulate this at one place so that investors/advisors have a perspective on this.

I Do Not believe in 100% equity allocation

Just because we do not have a debt fund does not mean that I am against fixed income/debt investing. A retired person of an advanced age, depending on regular income from accumulated savings needs a lot of fixed income/debt options. Depending on the financial plan, risk appetite based asset allocation for many individuals may have a debt allocation. Almost everyone needs some allocation for emergency funds.

Our having or not having debt funds has nothing to do with the need for debt investments in individual investment portfolios.

Death of real yield globally

One challenge that debt managers/investors have been facing is the low interest rate environment. As I write this, an estimated $13 trillion worth of bonds globally are trading at negative yields. This is, currently, not a problem in India. While interest rates are somewhat low when compared to the past, they are still in positive territory both in nominal and in real (post inflation) terms.

Our biggest competition is the Government/RBI

While negative rates are not a challenge in India, a different sort of challenge exists. That challenge is the dramatically higher interest rates on offer on "small" savings and direct bond issuances from RBI.

As I write this, the 10-year Government of India bonds are trading at a yield of 6.44% p.a. AAA PSU Bonds with 10-year maturity are trading at a) PFC 7.26% and b) IRFC at 7.32% (adjusted for annual vs. semi-annual compounding difference).

At the same time, RBI is directly issuing bonds to the public at 7.75% p.a. for a 7-year tenure.

Please realise that the yields on the tradeable GOI bonds and PSU bonds are before fund expenses. There would be some management expenses for each fund. These can range from 0.5% p.a. to 1.5% p.a. and would further reduce the returns to the investors. After deducting say an optimistic 0.5% from the pre expense returns, we would be left with 5.94% on the 10-year Government of India bonds and say 6.8% on AAA PSU Bonds.

Why should any investor take market risk/interest rate risk/credit risk and so on if risk free bonds are directly available at higher yields of as much as 1.8% p.a.?

Even at the short end, we have many banks that offer 6% to 7% on savings bank account. Savings bank account balances are protected up to Rs. 1 lac per account and hence for many investors they make good alternatives to liquid funds.

What about liquidity and taxation?

It is not that the higher yields on small savings and RBI bonds are hidden. Probably the only selling points for debt mutual funds have been liquidity and taxation. Let us look at these one after the other.

Liquidity

Sometimes, liquidity is desired, at other times it is not. If an investor desires only regular income and does not require liquidity of the principal amount RBI bonds just work fine. Bank deposits may also work well.

Taxation

Coming to taxation, there are avenues to save tax, which are even better than mutual funds depending on the circumstances.

For long term/retirement savings, EPF, PPF and NPS are among these. Firstly, there is no monetary limit on EPFO contribution. The employee can also avail of voluntary provident fund contribution and get returns up to 8.6% p.a. tax-free. Even businesspersons and professionals can set up their own organisations and become employees of that organisation to get Provident Fund/NPS benefits.

There are of course tax-free bonds for medium term or income generation needs.

All these are factors that make debt funds not that attractive from an investor’s perspective when considering the alternatives. Now let us look at it from the fund house perspective.

Instant liquidity to investors for investing in illiquid paper

The promise to investors of open-ended funds is that they can redeem funds anytime and get the NAV linked amount in at maximum a few days. However, debt investments beyond the most liquid government paper may get to be pretty illiquid. In such a scenario and especially where there is some adverse news on a corporate issuer, the early redeemers have an advantage on the remaining investors. Unlike banks, mutual funds have no provider of liquidity. Even if there is genuine desire on the part of a fund house to value a defaulted or a downgraded paper at fair value there is no reasonable basis to do so. If a corporate borrower defaults, should the bond be valued at 75% or 50% or 25% or should there be complete write off? There is no right answer to such questions in the absence of a traded price/estimate of ultimate realisation on the bond/time taken for resolution.

We cannot have investment grade bond market in the absence of a junk bond market

No matter how efficient auditors are or how vigilant rating agencies are. There will always be cases where an erstwhile investment grade bond gets downgraded to junk and/or defaults. This is not to absolve auditors/rating agencies of their recent lapses. They surely need to improve their game but even in an ideal situation, there would be cases of business failures or well-hidden corporate frauds. We need a liquid junk bond market where risk-taking buyers are there to buy downgraded/defaulted bonds at a price. This would enable funds to properly mark to market or sell downgraded and defaulted bonds. In the absence of a junk bond market, the liquid market gets restricted to just government bonds and maybe a handful of non-government borrowers.

We cannot have a junk bond market in the absence of a well functioning insolvency/bankruptcy law

Who would buy downgraded and defaulted bonds? There is no dearth of risk takers and bargain hunters if a well-established framework exists to recover money. If a debenture is secured by assets and there is a quick and easy mechanism to seize those assets and sell them, there would be a market for junk bonds (below investment grade bonds). While we have bankruptcy laws in place, there is currently a lot of litigation involved and some strange decisions like placing unsecured operational creditors at par with secured creditors. The timeline for resolution is also very long. Till these things get ironed out, it is difficult to have a thriving junk bond market.

Access issues for bond investors

In the equity market, each investor irrespective of size has equal access. An individual shareholder can sell one share to a foreign pension fund looking to buy millions of shares via the electronic anonymous order matching system. To enable this equal access, exchanges and regulators removed the minimum fill and all or none based orders facility to enable equal access to small investors. The fixed income market is in complete contrast. Even where some paper is liquid, minimum fill and All or None (AON) orders are rampant and we have situations where a buyer wanting Rs. 5 crore worth of investments cannot buy because the seller will sell only in lots of Rs.25 crores. While any investor can open a demat account and brokerage account and buy shares, the access to bond and money markets is still quite restrictive.

Why should anyone care?

Long story short, why should we care? A well functioning debt market is essential if we are to fund our infrastructure and growth needs especially when the banking sector is creaking. We need it for the insurance and the mutual fund sector to grow. We need to offer uniform yields to all investors and not selective high yields to individuals. If at all senior citizens need to be subsidised, that should be through targeted pensions and not by offering indiscriminate high yields on "small" savings. High small savings rates are a reason why RBI rate cuts are not transmitted through the system effectively. There will need to be a quick resolution process in case of defaults and the access to the debt and money markets has to be broadened rather than keep it a closed club.

I have not lost hope, and some day you might yet see a debt fund from PPFAS. :)