The year 2018 was one year when investors had a rude realisation that debt funds are not always safe and linear as they are made out to be. The IL&FS default, NBFC issues, oil prices, inflation contributed to a fairly volatile scenario for bonds. Investors now wonder, what is in store for 2019? Will things get better from here?
We reached out to Arvind Chari, Head Fixed Income & Alternatives with Quantum Advisors and got him talking on all these and more. Arvind has 15 years of experience in the Indian fixed income markets as a dealer, analyst, and portfolio manager.
Here are all the questions (in bold) and Arvind’s responses. Any emphasis is mine.
Let’s start off with the question top most on investor minds. One of the major shocks this year was the IL&FS default. What symptoms does the IL&FS default represent?
The IL&FS default issue is both – a company/ sector specific issue and a larger issue of lack of appropriate corporate governance. The default did show the stress in the infrastructure funding sector and the potential issues even in government projects.
IL&FS is the first case that I remember of a AAA company going directly to D – Default category. Although it was rated AAA, it never traded as a AAA.
IL&FS bonds used to always have a slightly higher yield/interest rate than other AAA companies. So the market knew and sort of priced its complicated corporate structure and messy balance sheet but most didn’t expect it to default.
That’s quite informative. Question then is when even experts and fund managers failed, how do investors go about safeguarding against such risks in their portfolio?
Sadly, individual investors, I believe, have no way to safeguard against such direct (credit) risks. It is always prudent to invest in debt through mutual funds which can help spread the risk and return. Hopefully the fund manager can manage the inherent credit and market risks.
Point taken. What’s your assessment of the current interest rate environment? Investors want to know what is in store for bonds in 2019?
2018 was extremely volatile. We have had the 10 year Govt bond yields move from around 7% to 8.25% and now back to 7.25%. I hope 2019 is smoother but I doubt that would happen.
The current low level of inflation especially food inflation is unlikely to sustain for long. We are heading into 2019 elections and we should assume that apart from farm loan waivers, the prices of food articles will also be raised to compensate the farmer and boost the rural economy.
The government has increased MSP (Minimum Support Prices) but market prices remain below that level and one can see continued farmer angst. So we expect inflation to go up and fiscal deficit to increase.
The expectation that given the change in the RBI governor, interest rates will come down sharply, is, I think, misguided. Oil is helping and if it remains so, the need for the RBI to hike interest rates will be lesser. Even if the RBI cuts rates now by 50 bps, it would see a situation where it may have to hike later.
Election and post-election outcome depending on who forms the government will hold a key determining factor for interest rates and currency.
Investors should remain cautious on debt investments; prefer high liquidity; and choose safety over returns in 2019.
With this background, how are the portfolios that you manage currently positioned?
We overweigh on risk over return, and thus our portfolios are likely to remain very defensive and risk averse. So in our bond funds, we will run low duration/maturity, high liquidity, low credit risks – at least in the first two quarters.
The warning is apt. However, it there a possibility to play up on some credit risk for aggressive investors say via credit risk funds?
I have a few fundamental issues with the current credit risk funds. The credit markets are not liquid as compared to the size of assets that they run. They haven’t seen a real systemic crisis yet like the one of 2008/2013. We are yet to see investor and fund manager behaviour at that time.
I have also found credit risk funds to have high expense ratios – so earning 9-10% and paying 1-2% expense; with net returns of 7-8%, with all the risks of default and illiquidity, just does not ring right to me.
Tactically, again only for a sophisticated investors, if the credit markets freeze again as it did in October 2018, there may be some selective good credits trading at good yields, but this is not for the retail investors.
Retail Investors should try and keep their investments and asset allocation as SIMPLE as they can. In most instances, given that investors are already exposed a lot to fixed income products through money lying in savings account, fixed deposits, PF, PPF – they actually might not need to invest in fixed income.
So one needs to look at the full basket of fixed income one has and then consider debt mutual funds, more so as an alternative to traditional fixed income instruments.
OK. I will push this further with you. Is there a likely opportunity for capital gains in the coming year?
Given where we are ending the year, unless oil prices continue to fall and food prices doesn’t rise, we see limited possibility of capital gains in fixed income from the current levels.
Sure. You have been vocal about fully mark to market policy for liquid funds? Could you take us through that thinking?
I have also been vocal about the need to have a rule to bar liquid funds from taking any credit risks.
We have to see it from the investors point of view. What does an investor want to achieve with a liquid fund?
What should then be the investment objective of the liquid fund?. To keep it liquid, safe and then earn returns over bank saving account rate.
All the recent cases of defaults have happened in liquid funds. That should worry SEBI and the mutual fund industry.
On mark-to-market for liquid funds, the logic is very clear, mutual funds are not bank deposits. The returns it tries to offer cannot be assured, linear.
All investments that a mutual fund makes needs to be fully marked to market to determine its fair valuation daily and to ensure that the declared NAV is real and realizable.
I don’t have data so I don’t know, but one needs to check for instance, if, prior to default, the IL&FS papers below 60 days maturity were marked to market to account for its deteriorating financial position.
Well, based on the information you have shared so far, I doubt that would be the case. What would be your view on passive investing in debt funds? We don’t see much around it in India.
I am not a big believer in indexing. You leave far too much to the judgement of the index creator and provider.
In Indian fixed income, an index with many constituents is practically difficult to replicate as the underlying liquidity in the bond markets is missing.
OK. But in terms of index/ETF investing, other countries, such as US, seems to have many products working in this space?
Globally too, Bond ETFs are not as big as equities. Precisely for the reasons I mentioned before.
So, that was the technical part. Now, let’s see what all contributes to your thinking process. What do you recommend to investors to read?
I read many boring books. I don’t think anyone is going to be enthused with what I read.
From what I read in 2018 –
Entrepreneurship:
- Shoe Dog (the story of Nike Founder)
- Why I stopped wearing my Socks – Alok Kejriwal (contests2win; games2win)
- How to fail at everything and still win Big – Scott Adams (Dilbert)
Economy:
- Economic Survey – Arvind Subramaniam (I really mean this..it is the best treatise on the Indian economy and an absolute must read for students and researchers)
Investing:
- I got aware on behavioral and bias in investing after reading Thinking Fast and Slow – Daniel Kahneman.
- The Undoing Project – which is the story of the collaboration of Amos Tversky and Daniel Kahneman in studying human mind and behavioral biases.
History:
- The Silk Road – Peter Frankopan (fascinating retelling of history from the point of view of Asia..as there is where all the action happened.)
This is in no way a boring list. In fact, it is a great list.
Thanks for sharing your views with us Arvind. I hope investors too have got a much better perspective on bonds and interest rates and how should they be planning their investment strategy.
Disclaimer: This interview if purely for information purposes. No part of this interview should be considered as investment advice. If you are not sure how to build your bond / fixed income portfolio, please talk to your investment advisor.
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