imgbd AMC Speak

4 strategies to deal with the BIG risk in credit funds

Amit Tripathi, CIO - Fixed Income, Reliance MF

3rd October 2017

In a nutshell

Amit believes credit funds will grow very significantly in the coming years as companies increasingly turn to the market for borrowings and savers increasingly turn towards funds for investments. All the more reason that we need to understand how fund managers are dealing with the biggest risk in credit funds - liquidity risk - which stems from the fact that the underlying portfolio is nowhere as liquid as the product offered to investors. Amit spells out 4 strategies that his team employs to effectively deal with this risk. He also makes a cogent case for including dynamic bond funds in the bouquet of fixed income options you take to your retail clients.

WF: Is the recent rise in core inflation something to worry about? How do you see the growth vs inflation dynamic impacting interest rates over the next 12 months? How are you positioning your duration strategies in this context?

Amit: The August CPI print of 3.36% was a tad bit higher than the market expectations. This was due to a combination of adverse base effect, seasonal increase in food prices and impact of 7th pay commission on housing prices. Typically, vegetables prices show sharp rise in Aug every year on account of seasonal factors. The Aug print shows higher increase than the seasonal factors. Cereals, Sugar (due to supply factors) and Pan, tobacco and intoxicants, prepared meals and condiments have shown increase. Housing prices rose by 1.4% m/m on account of seasonal factors as well as due to HRA impact of 7th Pay Commission.

The slightly higher CPI notwithstanding, we expect inflation to stabilize and remain near the RBI's target of 4% as good monsoons this year will keep food prices in check and sluggish demand and balance sheet constraints (banks and private corporates) is expected to curb growth. In fact any RBI policy action going forward will hinge more on growth prospects rather than further improvement in macro variables. Inflation can't fall much below current levels and CAD numbers will be higher than last year.The recent talk around fiscal expansion to support growth shows the concerns around low growth and aggregate demand in the economy. It will however be difficult to assume further monetary stimulus (rate cuts, more liquidity) if there is any significant deterioration in either the quantity or quality of fiscal spend which needs to be watched carefully.

In conclusion, we look for further accommodation of 50 bps from RBI given the current growth inflation mix, but will need to see through the current noise around the fiscal.

Accordingly, in our long duration products, we are running moderately high duration - nearly 5.5 years in Dynamic Fund and close to 7 years in our Gilt Fund. Further, in funds like Dynamic Bond Fund, where we have the mandate to manage the fund by taking tactical calls on duration and manoeuvre between different curves, we believe we will be able to add further value to investors over the investment horizon of 2-3 years.

WF: Dynamic bond funds as a category - which are meant to be all weather debt funds - have ceded a lot of mindshare in the retail space to accrual/credit funds. Are dynamic bond funds relevant in the retail space? How should they be managed for retail investors and how should their proposition be communicated to retail investors?

Amit: Accrual/credit funds tend to run low/moderate duration and generate most of their returns through the relatively higher portfolio yield. Dynamic Bond Funds, on the other hand, invest in the best credit quality assets across the yield curve, and generate alpha by managing the duration of the portfolio. Due to the difference in the method of generating returns and the lower variability associated with the same,accrual funds offer better visibility and hence, have been preferred over dynamic bond funds of late.

Dynamic bond funds,though,do make for a compelling investment case. The flexibility that these funds offer to the portfolio managers in terms of dynamically managing the portfolio duration, opportunity to implement spread strategies (more of G Secs vs SDLs and high grade corporate bonds, or vice versa, depending on their relative attractiveness), playing different tenors in the market (for instance, investing more in the 5-Year G Secs vs 10 Year G Secs), etc., inherently provides the opportunity for fund managers to generate 'alpha' in the funds. Moreover, what most tend to ignore is the lower credit risk associated with the underlying portfolio.

Dynamic Bond funds would be relatively more volatile than accrual funds, which run low duration, especially if you look at the near term. As long as investors are made aware of how these funds function, how they generate returns and the fact that intermittent volatility may be higher, dynamic bond funds should form a part of retail investors debt portfolio. It is all about setting the expectations right.

WF: What are the drivers for your huge conviction on the growth prospects for accrual funds in India? How much larger do you see this segment growing to in the next 5 years?

Amit: We would not risk putting a specific number but we do know that the growth of this segment will be phenomenal, for sure. These funds offer the potential to deliver higher returns than most popular traditional investments, investors would have reasonable visibility of those returns and the whole proposition would be tax-efficient.

My optimism stems from simple, basic assessment of our economic and demographic landscape. Indian households have traditionally been investing a larger sum in fixed assets than financial assets. A Recent Report by RBI mentioned that nearly 75% of Indian household wealth is in Real Estate and another 11% is in Gold. I expect this to shift significantly in favour of financial assets, as positive 'real rates' prevail in the economy. Within financial assets, as well, the preference has been to traditional investments such as Bank FDs, Post Office MIS, etc. With interest rates coming softening, the need for carry across investor portfolios will drive them to capital market product offerings, wherein accrual funds will stand out.A satisfactory track record of more than a decade, good credit risk management capabilities, attractive pre and post tax return potential make these products a natural fit into investor portfolios.

WF: How do you manage liquidity risk in your accrual funds, given the significant mismatch between the liquidity of the fund for investors and the relatively less liquidity of large chunks of the underlying portfolios?

Amit: Mutual funds cater to a variety of investors with different return expectations, different risk profiles and different time horizon of investments. Hence, it is very important to construct portfolios that could broadly serve investor requirements at any point in time. In other words, the underlying portfolio should be able to match the liquidity that is being offered at the product-level, like you rightly pointed out. This is especially pertinent for credit funds.

We are very conscious about this critical aspect and construct our portfolios with extreme diligence. Let me try and explain this through what we do in our credit fund - Reliance Regular Savings Fund - Debt Option:

  1. The first and foremost philosophy in the fund is not to lend long term. Most corporates, especially those that are down the credit curve may not offer visibility given the cyclical nature of their businesses. They would score relatively low on their balance sheet and financial flexibility. Hence, we do not commit investments beyond what is reasonably visible. You would notice that the Modified Duration of the Fund would never be more than 2 years

  2. We also try and match our assets with the business model of the issuer. For example, if we are lending to a MFI whose business model is to lend onward in small multiples and collect the same in smaller ticket sizes, we would also structure our investments in such a way that pay outs come back in instalments and not as a bullet payment.

  3. We ensure that the portfolio is extremely well-diversified - across issuers, sectors, maturity and rating profiles. This would mitigate the risks that concentration may pose.If you look at funds, you will notice that the portfolio has exposure to 70 unique issuers, while the fund offers yield pick-up through30% exposure in A rated equivalent papers, a good 60% of the portfolio is invested into bonds with rating profile of AA rating and better. The maturity profile of the portfolio would also be such that there is self-liquidation in the fund - at any point in time, a part of the portfolio will be maturing.

  4. You will find that nearly 1/3rd of the portfolio will be structured assets. In these structures, where possible and required, we would place additional covenants in the structure to enhance liquidity of the portfolio.

A combination of the above strategies would ensure that the risk is well-contained and the portfolio is fairly liquid.

WF: There seem to be two schools of thought on adherence to fund mandates - one which argues for sticking within the boundaries of fund mandates irrespective of market circumstances and the other which argues for some flexibility either to capture opportunities or protect downside. What is your perspective on this debate?

Amit: Fund positioning is absolutely sacrosanct to us. Each of our products is well-positioned, have well-defined contours, which we strictly adhere to. Our endeavour is to offer consistent investment experience in line with the scheme objectives without giving any negative surprise. Let me explain what I mean here with some examples. Consider our Short Term Fund. True to its label, the fund will never exceed 2.75 years of Modified Duration. And more importantly, even at an individual security level, we would not invest in securities having a duration of more than 5 years. In other words, in a short term fund, we will not take a call of investing, say, 10% of our portfolio in 10 Year G Sec because we are 'bullish' on that part of the market. We may be right sometimes producing extra ordinary returns, but when we are wrong, it could impact the portfolio quite badly, eroding investor confidence.

Similarly, in our Dynamic Bond Fund, while we do tactically manage portfolio duration, play across spread curves and tenors, we refrain from taking extreme, or what we call as 'digital', calls - i.e., either reducing duration completely to near zero levels or keep duration extremely high. We also do not mix credit and duration risks in our funds. Too much flexibility - be it taking digital calls or mixing various strategies within a fund - would actually increase the risk profile of the funds, which in our view is best avoided.

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