Debt fund managers who were betting hard on interest rates easing further, lost heavily after the credit policy was announced on 8 February. The impact was especially felt in the short-term debt funds category, if the maturity buckets of short-term and ultra-short-term funds are any indication. But this is also making these funds a tad riskier than they typically are.
The average maturity of securities is generally less than 1 year for ultra-short term funds and 1-3 years for short-term debt funds. However, as the table below shows, a good 38% of the ultra-short-term funds were operating with average maturity of greater than 1 year as of November 2016, compared with 12% overall in the past 5 years. Similarly, a huge 54% of the short-term funds were operating above 3-year average maturity, compared with 23% earlier. The fund managers’ wager is simple—lock-in investments at current levels with some way to go on the easing cycle, so as to deliver market-beating returns later.
To be sure, interest rates in the country have trended south since September 2014. With inflation cooling off, the focus of the Reserve Bank of India (RBI) has shifted to growth and economic activity. Expectations of rates easing further are, therefore, not without reason.
Then where is the risk?
Portfolio maturity is typically increased by substituting money market instruments such as commercial papers (CPs) and certificates of deposit (CDs) with longer-term bonds and non-convertible debentures (NCDs); a phenomenon particularly noticeable within the ultra-short debt category. However, since CPs or CDs are more liquid in nature than bonds or NCDs, the preference for higher maturity introduces an element of liquidity risk into the funds.
Also, while fund managers stand to gain from falling rates, they run the risk of not being able to divest the high maturity securities in case the tables are turned, i.e., if interest rates don’t fall as expected or start to harden instead. That’s the primary risk.
A look at the historical market performance indicates the potential impact on returns. We split the previous 5 years into three phases based on yield movements on the benchmark 10-year government security (G-sec). Phase 1 was from December 2011 to June 2013; phase 2 was from July 2013 to September 2014; and phase 3 was from October 2014 to November 2016. In phases 1 and 3, the yields declined 1.35% and 2.35%, respectively (easing), while in phase 2, the yields rose 1.11% (hardening).
Curiously, in a trend particularly evident in the short-term debt category, funds that ranked high on returns in phase 1 saw a significant drop in phase 2, while those that had lagged saw improvement. For instance, the average rank of the top 5 short-term debt funds in phase 1 deteriorated to 20.4 (out of 43 funds) in phase 2, while the five top performing funds of phase 2 had an average rank of 21.4 in phase 1. This shows a reasonably strong inverse relationship between the funds’ performance in phase 1 and phase 2.
It follows, therefore, that funds that invest in a high maturity portfolio and enjoy higher returns today, stand to take a harsher hit during the next downturn.
This played out recently when yields hardened 32 basis points (bps) on 8 February after the RBI decided to stand pat on rates. One basis point is one-hundredth of a percentage point.
Average maturities of the five worst-performing funds on that day stood at over 5 years in the debt short category, and over 1.5 years in the ultra-short term category. Funds with lower maturities were better insulated from the adverse movement.
The funds also experience greater volatility (standard deviation) of returns during downturns. The risk is all too visible in the debt short category, though not so much in ultra-short. However, as funds move from the ultra-short maturity range (up to 1 year) to the short-term range (1-3 years), their returns will be exposed to similar volatility. Even between phases 1 and 3, it is seen that phase 3 is higher on volatility due to the increase in maturity. In other words, along with lower liquidity and quantum of returns, an increase in maturity also increases uncertainty of returns.
All this only proves that the interest rate risk is all too real. Many investors tend to see equity funds as high-risk products and therefore prefer the security of debt funds. But even debt funds carry duration risks, which must not be overlooked, especially when investing for relatively shorter investment horizons.
Jiju Vidyadharan, director-funds and fixed income research, Crisil Ltd