Know how the returns are fixed for the Fixed Income funds

Have we ever taught how fixed are the returns from Fixed Income or Debt Funds. Fixed Income funds invest in Fixed Income securities. However, the irony is that the name is only fixed but the returns are certainly not in any of the Fixed Income funds. To understand the risk of investing in Fixed Income funds, we have to understand the risks of securities in which they invest.

The common risks associated with fixed income securities are credit risks, interest rate risks, liquidity risks, basis risks, yield curve risks etc. Most of the risks are well understood by the investor community and even if they are not understood, then they don't necessarily need to because the fund manager will manage those risks on the investor's behalf. However, the risk that most of the investors don't understand and which they need to understand is the "interest rate risk" because that is the risk which the fund manager manages but the investor actually decides when and how to take.

When investing in an equity fund, an investor has to first decide the level of the market and in which fund category he wants to invest like Index, Diversified, Large / Mid / Small cap fund, Sector specific fund etc. Similarly, while investing in a Debt Fund, an investor has to decide when to invest (in essence at what level of interest rate to invest) and then which scheme to invest in - Fixed Maturity Plan (FMP), Liquid fund, Ultra short term, Short term, Income funds or Gilt funds etc. The investor will only be able to take an informed decision while deciding to invest in a debt fund if he understands and appreciates the key risk affecting Debt funds i.e. interest rate risks.

This article will briefly explain the highly difficult and mathematical measurement of interest rate risk in simple terms and then guide you in which category of debt fund to invest during each phase of the interest rate cycle.

A long term Government of India Security (GSec) may have zero credit risk (because the Government can literally "print notes" and pay back the loan), but it has one of the highest interest rate risks. Interest rate risk is directly related with the maturity of a security. Now, I will touch upon two very important contributors of interest rate risks in this note - duration and convexity.

Duration

I have seen many investors to confuse duration with maturity. However, they both are distinctly different. Maturity means when the fixed income security matures and pay back the principal.
For example, the maturity of a 10-year paper will be 10 years at the time of issue.

On the other hand, duration is the time within which the investor receives back all the cash flows related to the security i.e. interest and principal. For example, if there is a 10-year maturity paper paying yearly coupon at the interest rate of 8.0% p.a. issued at par (Rs.100) will have the following cash flows, 8 + 8 + 8 + 8 + 8 + 8 + 8 + 8 + 8 + 108 which will be paid at the end of every year for the next 10 years till it matures. The Rs.8 is the interest at 8.0% p.a. on Rs.100 par value.

Kindly note that at the end of the 10th year the investor will receive Rs.108 i.e. Rs.100 of principal + Rs.8 of the 10th year's interest.

This example clearly shows that although the maturity of the security is after 10- years, the investor receives cash flows frequently at regular intervals much before the final maturity of the security. That brings me to the concept of duration. The duration of a bond is defined as the "weighted average term to maturity of a security's cash flows". Since the cash flows on a security are received piecemeal before the actual maturity of the security, the duration of all coupon paying bonds will be less than its maturity. And as a Zero coupon bond does not pay any interest during its life, its duration = maturity. There are different forms of duration. The basic one is the Macaulay or unadjusted duration. The one which we use for our calculation is the adjusted or Modified Duration. I would not go into the understanding interest rate risks associated with fixed income securities.

Duration is useful primarily as a measure of the sensitivity of a bond's market price to interest rate (i.e. yield) movements. It is approximately equal to the percentage change in price for a given change in yield.

For example, for small interest rate changes, the duration is the approximate percentage by which the value of the bond falls for 1% per annum with the increase in market interest rate. So a 10-year bond with a duration of 7 years would fall approximately 7% in value if the interest rate increased by 1% per annum. In other words, duration is the elasticity of the bond's price with respect to interest rates.

Convexity

Duration is a linear measure of how the price of a bond changes in response to interest rate changes. As interest rates change, the price does not change linearly, but rather is a convex function of interest rates. Convexity is a measure of the curvature of how the price of a bond changes as the interest rate changes. Convexity deals with the curvature of the price / yield relationship or chart. Note that duration can be either negative or positive depending on the way the interest rates moves but Convexity is always a positive feature of the bond. The exception to this rule is in the case of "callable bonds" where the convexity is a negative feature. By positive feature of convexity, I mean that for a given change in interest rates and the modified duration of a bond, the change is that the price of the bond will be in favour of the investor. For example, because of the positive feature of convexity, when interest rates rise, the price of the bond will fall less than that indicated by the duration and when interest rates fall, the price of the bond will rise more than that indicated by the duration.

Interest Rate risk and selection of different Debt Funds

Now, let us understand at what point within the interest rate cycle it is ideal to invest in which category of Debt Fund:

• Fixed Maturity Plan (FMP) : A FMP is for a fixed period of time and hence locks in at the prevailing interest rate for that period and therefore does not have any interest rate risk. However, the FMP has a very high "opportunity loss risk." If you lock in long term FMP just before the beginning of an interest rate hike cycle then you will loose the opportunity of earning higher yields. Therefore, investment in a FMP should ideally be done at the peak of the short term policy hike interest rate cycle. Currently, we are at that point of time which makes it ideal to lock Long term funds in to FMP to get high yields benefit.
• Liquid Funds: These funds are for parking surplus and hence interest rate considerations are not to be taken.
• Ultra Short Term Funds: If the liquidity need can be stretched to a couple of weeks, then the interest rate risk in the Ultra short term will smoothen out and most probably give better returns than a liquid fund.
• Short Term Funds: These should be considered when there has already been substantial hike in short term policy rates and importantly this should result in the yield curve being inverted or flat.
• Income Funds: These funds would become attractive when there has been substantial hike in short term policy rates and importantly the yield curve is steep or at least upward sloping and the spread between GSecs and Corporate yields are high.
• Gilt Funds: These funds would become ideal when there has been substantial hike in short term policy rates and importantly the yield curve is steep or at least upward sloping and the spread between GSecs and Corporate yields are low.

Kindly note the difference between when to invest in short term, Income or Gilt Funds - All the three after substantial hike in short term policy rates but short term funds when the yield curve is inverted or flat, Income funds when the yield curve is steep/ upward sloping with high yield spreads as compared to GSecs while Gilt Funds when the yield curve is steep/ upwards sloping with low yield spread as compared Corporate bonds.

Conclusion

The decision of when and in which category of a Fixed Income to invest is of paramount importance for enhancing returns from your debt allocation. As with fixed income products, the name is only fixed while the returns are certainly not. If you follow these simple principles then you would be able to generate above average returns from your debt allocation which will many a times even put your equity portfolio into envy.

- Mehrab Irani

The author is the General Manager - Investments of Tata Investment Corporation Limited and writes blog called intelligentmoney.blogspot.com. He may be reached at mehrabirani10@gmail.com