Double whammy for debt fund investors: Flat rate cycle, tighter regulation

A flat interest rate cycle and tighter regulation may weigh on returns

The Franklin Templeton India (FT) debacle in April 2020 triggered changes to debt-fund structures. Apart from holding the Kudvas guilty of insider trading, Sebi said the six FT schemes which folded up took high risks in buying bonds rated AA or less, and also that the Macaulay duration of portfolios was manipulated.

Sebi tightened the classification and introduced a new risk matrix. Under a 16-category classification, debt funds must maintain Macaulay Duration in the stipulated duration, and hold around 80 per cent of portfolio in instruments of the mandated class, or classes. In addition, from December, debt schemes must rate themselves on a 9-cell matrix, by credit risk, and interest rate risk.

The Macaulay Duration (MD) of a portfolio is the weighted average duration of assets held with respect to tenure, and percentage of AUM or assets under management. MD is to be used as the measure of interest rate risk. Credit Risk is to be measured by weighted average of credit risk of every instrument as a percentage of the AUM. The lower the MD, the less the deemed interest rate risk. The higher the rating, the less the credit risk. Every asset is assigned a numerical value between 1-13, with the higher value being less risky.

The majority of debt fund investors are corporate but there is also retail interest. Over the past few years, investors have learnt debt is often as risky as equity. It may be even more risky in instruments like perpetual bonds. Equity investors in YES Bank have taken a beating, but investors in YES Bank’s perpetual bonds have lost everything.

Trust in credit ratings has been eroded. There have been defaults by corporates with high credit ratings such as IL&FS, DHFL and YES Bank. Schemes from fund-houses like FT which had an excellent track record have had to shut down.

There is consistently more AUM in debt fund schemes than in equity- oriented schemes everywhere. Debt funds hold multiples more AUM than equity funds in hard currency markets. Most investors, even savvy corporate investors, find it hard to navigate wide variations in risk, tenure and yields. SEBI’s attempts to strictly outline schemes may help in the long run.

One factor retail investors overlook is that historical returns are no use in assessment of debt funds. Liquid funds give predictable returns. These are short-duration in a segment with few defaults. But if duration is longer, the interest rate cycle is critical.

If rates are falling, debt funds can make high returns. If rates are rising, they struggle. If rates are flat, they may still struggle. That’s because funds trade instruments apart from holding some of their portfolio to maturity. A falling interest rate enhances the value of an instrument issued at a higher interest rate.

The rate cycle has flattened, after cuts in FY21. The RBI will not raise policy rates. It is trying to support revival and it must manage a huge government borrowing programme. But it cannot cut rates either, given high inflation. This leaves little room for excess returns by trading debt. Debt funds may go through the double-whammy of a flat rate cycle and tighter regulation. As a result, investors may rebalance, switching a larger proportion to equity.