How to readjust your fixed income allocations
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Fixed deposit rates, bond yields, and debenture coupons have fallen; small savings rates are being reset lower; and duration-linked returns for debt mutual funds have declined. There is hardly any room for your fixed income allocation to be able to deliver the 8%-plus kind of annual returns you may have seen 18-24 months ago.
The lower returns will have an impact on the overall portfolio return as well. With equity markets near all-time highs, there are very few places to hide if you want to enhance the overall yield on your portfolio. In such times, you may be tempted to switch to securities and funds that deliver slightly higher returns. However, with the higher return comes more risk.
Here is what you need to consider before readjusting your fixed income allocation.
What are the alternatives?
If you want to earn slightly more than the 7% annualised return that most fixed income products are currently giving, what can you switch to?
One option is to consider high-yield credit opportunities funds that can potentially give 9%-plus returns. But the enhanced returns come with enhanced risk as well. Most of the funds in this category have 90-95% of their assets invested in securities that are rated AA, A and BBB. This means that this category of funds invests in bonds that are less than the top rated, and the most secure, in order to get more returns. There is an improvement in the credit environment as indicated by Crisil’s credit ratio (number of upgrades to downgrades), which improved to 1.88 in the second half of the current fiscal year, from 1.22 in 2017. However, some of this positivity is reflected in corporate bond yields, which have already fallen. Moreover, this does not alter the overall default risk of bonds held in such portfolios.
“The credit spreads are down sharply, and we feel that the incremental risk taken to get that 1-2% additional returns is not worth it,” said Prateek Pant, head-products and solutions, Sanctum Wealth Management.
Credit risk in debt is binary, which means that either you will get all your payments and the capital back or, in case of default, you are likely to lose all your money.
Given that economic growth is yet to pick up sufficiently to have a positive impact on earnings, banks are still reporting high non-performing asset levels, which means that there is concern about corporate cash generation.
Hence, it is critical to track the proportion of high-risk, high-yield debt securities in your portfolio—which you may have bought directly or through funds. Funds that have a higher allocation to lower-rated securities, carry higher risk.
Move to equity?
The second option, according to financial advisers, is to add a bit of equity risk wherever the client is comfortable.
“Our focus remains around the objective someone has. Are they looking for capital protection, growth or something midway? That determines the time frame for the investment,” said Tarun Birani, founder and chief executive officer, TBNG Capital Advisors. “If an investor is not ready to take more risk, return expectations need to be lowered. If one is open to adding some equity, dynamic asset allocation funds offer a suitable option with 8-10% post-tax returns; these funds are more stable than pure equity funds, and have significantly lower standard deviation,” he added.
Be careful when choosing the kind of equity allocation to shift to. Equity is not a substitute for debt: it is more volatile in prices, which impacts near-term returns; and it does not offer the kind of stability and capital preservation that debt investments provide. However, if some equity exposure is blended into a primarily debt fund, or if the downside is limited, one may look at equity as an alternative.
“One option is to consider equity income funds, which combine a portion of equity, some arbitrate opportunities within equity, and the rest in debt. The debt and arbitrage portion can typically deliver 7-8% annualised returns. To that extent, the structure is fairly stable for capital preservation, despite the long equity component,” said Pant, adding that they are also looking at opportunities such as equity portfolio management services (PMS) “built around corporate actions like buybacks that provide a floor to fall in prices”.
Keep in mind that all these funds are not meant for short-term exposures of a few months. You should remain invested for at least a year; ideally for 2-3 years. Also remember that while this shift may cover up the yield gap in your portfolio, it also adds to the risk.
Fixed income giving lower returns is a reality now. “We have witnessed a cut of 200 bps (basis points) in repo rate by RBI since January 2015. As a result, government and corporate bonds have seen a decline in yields. Fixed income investors with low risk appetite should expect lower fixed income returns going ahead,” said Kunal Valia, director and head-funds and ETFs, Credit Suisse Wealth Management India.
For investors with higher risk appetite, Valia also suggests long short funds under the category AIF III umbrella. But such sophisticated products come with different risk-return matrix and liquidity constraints, he added.
If adding risk does not suit you, it is best to lower your overall returns expectation for the time being, and manage other aspects of your finances like spending and saving.
All is not lost
Interest rates don’t work in isolation. The rates are lower now because inflation has fallen. The Consumer Price Index (CPI) inflation was at a high of around 9.1% in December 2013 compared to the current level of 3.5%. This means that the overall prices of goods and services are rising at a slower pace than earlier, and the value of your rupee is also declining at a slower rate.
“We can’t do much about the lower returns. But it helps to remember that inflation is lower too, which means your real return is protected,” said Karthik Jhaveri, founder and director, Transcend Consulting.
Ultimately it is your strategic asset allocation that will matter. It is unwise to change that too much in a bid to fill the 1-2% return gap on the debt side. As the cycle turns, these returns will start to move up again. Too much change in the overall asset allocation might mean that you end up taking on more risk and don’t meet the long-term return objective.