Riding the interest rate wave with debt long short funds

DLSF allows fund managers to invest in a pool of bonds.

Many investors use debt mutual fund schemes to take exposure to fixed-income instruments. While most want to benefit from the regular income with relatively less volatility, some have specific motives such as benefitting from falling interest rates. Though debt funds have served such goals over time, there is a need to introduce refined investments in fixed income space. Debt long short fund (DLSF) does just that by allowing a fund manager to short bonds. Let’s understand how this strategy can help investors improve risk- reward in fixed income investments.

DLSF allows fund managers to invest in a pool of bonds. The regulator neither specifies duration nor the quality — credit rating. Put simply, a fund manager can buy bonds of any duration and of any credit rating. In mutual funds, this goes closer to a dynamic bond fund. It does not put any restrictions on a fund manager like we see in a corporate bond fund wherein a fund manager is expected to invest in bonds with AA+ credit rating and higher. The flexibility given to a fund manager of a DLSF should allow her to construct a portfolio that optimises the risk-return balance depending on her view on interest rates.

The key provision here is a fund manager is allowed to go short using exchange traded debt derivative instruments. Here a fund manager may want to short a bond if she is of the opinion that the interest rates are expected to go up. The fund manager can also short sell a bond if she is expecting the issuer is going to see a credit rating downgrade soon.

For the uninitiated, bond prices fall when the interest rates go up. Credit rating downgrade of a bond indicates increased credit risk and hence investors demand more risk premium in the form of higher yield by lowering the price of the bond concerned. Selling short involves selling a security which one does not own, using a derivative instrument or after borrowing it from another, with an intention to buy it back later. If the price falls after short-selling, then the transaction fetches profit.

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DLSF, thus, can put a fixed income investor in an advantageous position by allowing her to ride movements in interest rates on both sides, which won’t be possible in a debt mutual fund which cannot short sell a security.

This being a fixed income product, there is no exposure to equity markets and associated volatility. However, an investor is exposed to the risks such as credit risk – the possibility of the issuer of the bond not paying principal or interest, or both as per agreed terms. An investor is also exposed to interest rate risk. If the interest rates go up, then the prices of bonds held in the portfolio fall leading to capital loss. Despite these risks, a prudent fund manager can generate healthy risk-adjusted returns in a DLSF. A fund manager’s role in such an actively- managed fixed income product is crucial.

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The gains booked by selling units of DLSF will be taxed as per slab rate. This is similar to the taxation treatment of the capital gains in debt mutual funds and interest received on fixed deposits and bonds. However, the tax liability materialises only when a fixed income investor sells units. By holding the units for a long term, an investor can effectively postpone the tax liability, just like a debt fund. In the case of fixed deposits and other interest paying instruments, the tax is payable on an accrual basis. This provision of postponing tax liability, can effectively help a long-term investor to plan her taxes by holding on to DLSF till she retires and booking profits only in lean income years.

Investment threshold for DLSF is kept at minimum Rs 10 lakh, which suits many investors. Portfolio management services and alternative investment funds require a minimum Rs 50 lakh and Rs 1 crore, respectively. Investors must also keep a tab on the expenses of the scheme along with the credit quality and the extent of diversification of the bond portfolio of the scheme before investing. Investors can consider allocating money to units with a minimum five years view.

On the whole, a carefully chosen DLSF can be an effective diversification for a fixed income investor with a long term view.