13.1 – Debt jargons

As we enter the 27^th day of the nationwide lockdown, I hope you and your loved ones are staying home, staying safe. The number of COVID19 cases in India has crossed 17,000 with Maharashtra topping the charts with over 3,500 cases. I hope all of this ends soon and we can all get back to our normal lives, until then the only mantra is ‘social distancing’, I hope you are following this diligently.

I think many people across the country are using the lockdown opportunity to learn something new and educated themselves. The traffic on Varsity has shot up quite a bit, here is the pageview snapshot from Google Analytics –

Along with the pageview,  the number of queries pouring in has also shot up. We spend several hours every day to answer your questions.

So if you find the new chapter update a bit slow, then please do understand its because of the increased load 🙂

In the previous chapter, we introduced a term called ‘Macaulay Duration’. If you recollect, Macaulay duration measure in years, the time required for the bondholder to recover the price paid for the bond by the bond’s cash flow. We did not discuss the math behind Macaulay duration because that’s outside the scope, but as I hinted in the previous chapter, the next module is on fixed income security (mini-series) where I’ll try and take this up in detail.

However, while we cruise along, there are few bond relationships that you need to know –

• The yield of a bond and the price of the bond are inversely proportional. If the price of the bond increases, the yield of the bond decreases and vice versa
• Interest rates and bond price are inversely proportional. If the interest rates increase, the bond price reduces and vice versa.

While we are at it, let me introduce another term – ‘ Modified Duration’, of the bond.

The modified duration (measured in years) of a bond is essentially the sensitivity of the bond’s price to the change in interest rate. So if a bond has a modified duration of 3.2 years, then –

• A 1% increase in interest rate decreases the bond’s price by 3.2%. A 1.5% increase in the interest rate, lower the bond’s price by 4.8%
• A 1% decrease in interest rate increases the bond’s price by 3.2%. A 1.5% decrease in bond price, increases the bond’s price by 4.8%

We can generalize this – Higher duration funds have a higher sensitivity to interest rate changes. So a 1% change in interest rate reduced the price of a longer duration fund in a greater magnitude compared to a low duration fund and vice versa.

In the context of a mutual debt fund, the modified duration is at an aggregate portfolio level. In the example above, say for a 1.5% increase in the interest rate, the debt fund’s NAV is likely to decrease by 4.8%. I hope you get the drift.

As a debt mutual fund investor, you are in the right spot if you are aware of the few points we have discussed so far. Along with these few points, as a bondholder or a debt mutual fund holder, you need to be aware that the mutual fund you are holding is susceptible to –

• Credit risk – The risk that the bond held by the debt fund can get downgraded
• Default risk – The risk that the bond issuer defaults on a coupon or principal repayment

Of course, now you also know that the bond price has an interest rate risk, but at this point, let us just assume the fund manager can hedge the interest rate risk.

Anyway, we will get back to the good old debt mutual funds. In this chapter, we will continue our discussion and take a few more debt (sub) categories. We will start the conversation with the low duration, money market, and short-duration funds.

13.2 – Low duration and Money Market

We looked at the ultra-short duration bond fund in the previous chapter. The defining criterion for the ultra-short duration fund was the Macaulay duration of the portfolio. As per SEBI’s classification, at the aggregate portfolio level, the Macaulay duration of the ultra short term duration fund has to vary between three to six months.

Next up is the low duration fund. The low duration fund is just like the ultra-short duration, only that the low duration fund, the  Macaulay duration at the aggregate portfolio level varies between six to twelve months.

The credit risk of the low duration fund is similar to the ultra-short duration fund. Hence it is imperative for the investors to glance through the asset quality (paper quality) of the fund.

Have a look at the portfolio of the IDFC AMC’s low duration fund –

As you can see, IDFC has 100% of its portfolio invested across various AAA papers. However, just because the fund has only AAA papers, does not imply zero credit risk. Remember, we discussed the Vodafone case in the previous chapter.

While the credit risk exists, the interest rate risk for the low duration fund is low. Have a look at the modified duration of IDFC’s Low duration fund (published in the fund’s factsheet) –

The modified duration is 289 days. I can convert this to years by dividing this by 360 –

= 289/360

= 0.802

This means to say for every 1% increase or decrease in the interest rate, and the NAV is likely to decrease/increase by 0.802%, which as you can imagine is not much.

By the way, not all funds report modified duration in terms of the number of days. Modified duration is expressed in terms of years.

For example, the Nippon India low duration fund expresses the modified duration in years, which is 0.94 yrs.

So when the fund expresses in years, you need not divide by 360. Instead, you can use the number directly.

While we are at it, which of the two low duration funds do you think is risky in terms of modified duration?

IDFC’s Low duration Fund with a modified duration of 0.802 or Nippon India’s low duration fund with a modified duration of 0.94?

Here is a task for you – why do you think Nippon India’s low duration fund has a higher modified duration? Can you look into their portfolio (as of April 2020) and get your answer?

If you can answer these questions with ease, then we are headed on the right track 🙂

Lastly, who should look at investing in a low duration fund? This is best suited under situations where you want to park your money for a short duration and utilize the funds towards a specific goal at a later point.

Next up is the money market fund.

The money market fund is somewhat similar to the low duration fund. Here is SEBI’s classification of the money market fund –

As you can see, the maturity is capped to one year, similar to that of low duration fund; the only difference is in terms of the portfolio constituents.

A low duration fund can invest in both money market instruments and bonds but ensure at the aggregate portfolio level the duration is between 6-12 months. The money market fund, however, can invest only in money market instruments. The money market instruments usually consist –

• ‘Commercial Papers’ or CPs, issued by companies. CPs are unsecured
• ‘Certificate of Deposits’ or CDs. Banks issue CDs to entities depositing money
• T-Bills, issued by the Government, carries a sovereign guarantee.

So just to summarize, the fund manager of a low duration fund can invest in CPs, CDs, and perhaps even in a bond with two years maturity. However, a money market fund manager can only invest in CDs and CPs.

Let me ask you two question –

• What is the risk of investing in a money market fund?
• What do you think will be the modified duration of a money market fund? Will it be 1, greater than one or less than 1.

Do pause here, think about it, try to answer yourself.

Have a look at the factsheet of UTI’s Money market fund –

You will find the answers for both the questions here.

• The money market fund is exposed to credit risk. As you can see, 9.39% of the portfolio is invested in a single company’s CP or CD. Of course, the company’s paper enjoys a high rating, but I want you to remember the fact that these ratings can change. So yeah, credit risk exists in a money market fund.
• As you may have guessed, the modified duration will be under one year for a money market fund, which implies that the interest rate risk for these funds is low.

Investment philosophy in the money market fund is similar to the low duration fund. In fact, many investors often choose between low duration and the money market fund.

13.3 – Short Duration and Medium Duration funds

Next up is the short duration fund. Let’s start straight with SEBI’s definition –

The Macaulay’s duration of the short duration fund has to range between 1 and 3 years. After reading the SEBI definition, what is the first thing that comes to your mind?

Well, I hope you think about it from a risk perspective. With an increase in the duration, the modified duration also increases – which means the risk associated with changes in interest rate is higher with a short duration fund (and the medium duration fund).  Do note; this was not so much of a concern with the low duration and money market fund (or even the ultra-short duration fund).

Of course, credit risk continues for short duration fund as well. Have a look at the rating profile of the Mirae Asset Short Term Fund –

As you can see, the fund has a mix of AAA, AA and A1+ debt papers in the portfolio. For the same fund, look at the modified duration –

The modified duration is 2.67 years, which means, for every 1% increase in the interest rate, the fund will drop 2.67% in its NAV. The risk associated with the short-term fund is higher compared to all the other funds we have discussed so far.

Also, do notice the Macaulay duration of the fund, it is below 3, as SEBI has defined.

With a considerable amount of risk, you need to be clear with your investment objective in these funds. Invest in these funds only if you have an investment horizon of at least three years in perspective. Of course, with the increased risk, the return expectation is also higher. I think it is prudent to expect about 7 (ish) % return on these short-duration funds.

I think by now, you must have got the hang of how to understand the basics of debt fund.

Here is the SEBI’s classification of a Medium duration fund –

As a task, why don’t you do look upon a fact sheet belonging to a medium duration fund and answer these questions –

• How is the portfolio composition? What do they hold in the portfolio? How are the papers rated?
• What do you this is the credit risk here?
• What is the Macaulay duration? Does it match SEBI’s mandate?
• What is the modified duration? What do you think is the risk associated with the interest rate change?
• What is your investment horizon if you were to invest in these funds?

I’m reasonably sure that you can carry out the above task with ease. If you find any difficulty of any sort, then please do leave a query at the end of this chapter and I’ll be more than happy to help you with it.

In the next chapter, we will take up the Credit risk, dynamic bonds and the gilts. However, there is one last thing we need to discuss before we end this chapter.

13.4 – The  Franklin India debt fund saga

On 23^rd April 2020, Franklin Templeton (India) AMC made an announcement that shook the entire debt fund world.

In an unprecedented move, Franklin has decided to close six of its debt funds, which includes their low duration fund and ultra-short duration fund. The AUM across these six funds is roughly Rs.27,000 Crores.

The reason they cite is – because of the current economic situation, there is a surge in redemption, leading to a liquidity crunch within the AMC.

To put this in perspective, Franklin witnessed a surge in redemption to the extent of over Rs.9000 Crores in March 2020, which as you can imagine is one-third of the AUM across these funds.

Unfortunately, the secondary bond market in India is not liquid enough. It is not easy for the fund managers to quickly liquidate the bonds from their portfolio. For this reason, most of the bonds held to maturity. Of course, the AMC plans to have enough cash to meet daily redemptions, they do this in several ways, including a technique called laddering, wherein they have a blend of papers maturing in different timelines. The liquidity arrangements work when business functions as usual. But as we clearly understand now, things go helter-skelter when tables turn.

None of the AMCs would be (at least up until now) prepared for such a steep surge in redemption.

Hence to ease the situation, Franklin has decided to close down the schemes completely and lockdown the funds entirely, which implies that if you are an investor in these funds, then you cannot place a redemption request.

Please note, the AMC is not winding down the scheme because of the credit or interest rate risk. Folks at Franklin are outstanding in the debt fund game, and they have a vast experience in this segment, but unfortunately, they are now threading on a different territory.

Therefore, dear readers, when investing in debt funds, along with the credit and interest rate risk, factor in a new risk – liquidity risk.

But of course, how do you quantify and apply liquidity risk in a real-life scenario? Well, I don’t know that just yet. However, does this mean that you should completely stay away from debt funds?

No, not at all.

Debt funds play an essential role in asset allocation, and it should play its part in your portfolio. The COVID19 situation if not for anything, has yet again highlighted the importance of asset allocation.

More on this as we cruise through this module!

Stay home, stay safe!

Key takeaways from this chapter

• Bond yields and bond prices are inversely proportional
• Interest rate and bond prices are inversely proportional
• Modified duration helps us understand the change in NAV of the fund (in the context of debt fund) for every 1% change in interest rate
• Low duration fund has credit risk, but low-interest rate risk
• Money market fund has credit risk, but low interest rate risk
• Short and medium duration fund has both credit and interest rate risk
• Debt investors have to factor in liquidity risk along with credit and interest rate risk