Debt funds expected to generate better returns than last 2-3 years: Amit Tripathi of Nippon India MF

There is more stability in terms of flows in debt funds in the recent past. This is because the yields have risen with the Reserve Bank of India (RBI) increasing the repo rate—the rate at which banks borrow from the central bank—five times since May 2022. RBI is expected to further hike policy rates before taking a pause. Against this backdrop, Amit Tripathi, CIO – Fixed Income Investments, Nippon India Mutual Fund tells Business Today why debt funds are a better option to invest.

BT: Is it a good time to invest in debt funds?

Amit Tripathi: Notwithstanding the need to always have a balanced allocation between debt and equity driven by time horizons and risk appetites, there are specific tailwinds which will help debt funds perform in the next few years, compared to what we have seen in the last few years.

The first and foremost is a significant improvement in the yields across tenors and across rating categories in the last 18 months. The entire G-Sec curve starting from one year onwards is now yielding more than 7 per cent and in case of corporates is closer to or higher than 8 per cent. Second, RBI and other global central banks have done a series of rate hikes with the objective of bringing down inflation going forward, and other macro parameters like the Fiscal Deficit and the Current Account Deficit, which have a bearing on aggregate demand and inflation pressures, are also improving, i.e. on a declining path. Third, the credit risk across most of the corporate spectrum is low owing to very strong and conservative balance sheets and healthy domestic business environment.

As we speak, yields across the markets starting with Repo rate onwards may be close to peak levels, and may settle in and around current levels near term, before starting their downward trajectory in the next 12-18 months as headline growth and inflation data start becoming conducive for a more benign rate regime. That offers a good combination of starting high carry (yields), with potential capital gains over a 2-3 year period, which always is the best way to generate attractive returns from debt funds.

Hence, we can conclude that it is a good time to be investing in debt funds across the duration as also the credit spectrum. The only aspect that investors should be careful about is the right choice of product basis their investment time horizon and risk appetite.

BT: How much return one can expect from debt funds compared to their past year's performance?

Amit Tripathi: The gross portfolio yields across debt fund categories have moved by nearly 200 bps in most debt categories in the last 18-24 months. That itself gives a good base for reasonable returns if the investor chooses the right product basis his time horizon. Add to that the potential that exists of incremental capital gains that could materialize over the next 12-24 months. So, it would not be improper to expect returns at or above the current higher carry levels across most medium to long term debt categories given the right holding period. Even in shorter tenor products like liquid and ultra short-term funds, carry in itself will generate better returns going forward than we have seen in the last 2-3 years.

 BT: What type of debt funds should one invest currently?

Amit Tripathi: The first principle is defining one’s investment horizon/holding period. In the current environment, investors should choose debt funds whose duration profile is similar or somewhat higher than their holding period. Please note that the key data point is the duration and not the average maturity, and that data is readily available in public disclosures like fund factsheets etc. For eg, a investor who has an investment horizon of 12-18 months or higher can evaluate products like Short Term Funds, Banking & PSU Funds, Corporate bond Funds etc. which typically run a duration profile of 1.5-3 years. Similarly, an investor with investment horizons of 3 years or more could consider long term debt funds like Gilt Fund, Income Funds etc.

For investors who are looking at debt funds with a 1.5-3 year duration profile, depending on their comfort and risk appetite, they could also choose Credit Risk funds vis a vis High Grade funds, since they offer higher starting carry.

BT:  Have interest rates plateaued or do you expect another hike?

Amit Tripathi: We think the policy rates as well as market interest rates for the most category of debt assets, are near peak levels. Given RBI’s focus and directional target of 4 per cent on inflation and given the higher degree of uncertainties that make macro data forecasting more difficult, any Emerging Market Central Bank like the RBI would always err on the side of caution. With that background, one can’t rule out any further rate hikes, although the probability and potential size of those is much lesser than what we have seen in the last 12 months. Moreover, this non-zero probability of small if any further rate hikes, as well as tight liquidity conditions, are already getting priced into the market as we speak. As long as the market is expecting and adequately pricing these smaller rate moves going forward, we aren’t overly worried about them from a potential return perspective.

BT: What should one be aware of while investing in debt funds?

Amit Tripathi: The three things that the investor should be aware of are, a) the right investment time horizon for various type of debt funds, b) the potential risk factors including credit risk and interest rate risks, which differ across product categories in general and c) the process and risk management practices of AMCs while managing these open-ended debt funds. Returns are ultimately a function of the markets and the discipline exercised while managing these funds, and hence the focus should be more on the above factors while choosing the right funds.

BT: Which categories in debt funds are giving the highest returns, currently?

Amit Tripathi: Carry across fund categories is broadly similar in the 7.5 per cent to 8 per cent range, barring very short term overnight and liquid funds, which have carry yields of around 6.5 per cent and 7 per cent respectively. Credit Risk Funds offer a higher carry closer to 8.5 per cent and above owing to their strategy of investing across instruments of varying credit risks.

Given this reasonably high starting carry yields, as long as the choice of fund is driven by holding period rationale and the right understanding of the interim/ultimate risks, potential returns will most likely be optimal.

BT: Last year saw the pullout from debt funds. How has been the trend now?

Amit Tripathi: There is more stability in terms of flows in the recent past. Having said that, most allocation in the open-ended category till recently has happened in the shorter end (Liquid & Ultra Short-Term Funds). Of late we are seeing selective incremental flows into medium- and long-term debt categories as well, as investors are getting more comfortable with the macro and interest rate environment. Another category of products which have also seen good inflows are the Target Maturity Funds, which are good entry-level products for retail investors.

BT: Has demand for market linked debentures been impacted after the Budget proposals? Which category of funds can give similar risk adjusted return?

Amit Tripathi: While the market size of outstanding MLDs is not large in the context of debt capital markets, select NBFC issuers specially in the AA and below rating category have issued these bonds regularly in the last few years. The tax arbitrage offered by these bonds, if sold prior to final fixing/maturity is what has driven the demand for these debentures. As a corollary post the budget announcements, we expect demand to reduce meaningfully and consecutively those issuers who were issuing these MLD bonds will shift to plain vanilla debt issuances for raising resources.

One category of funds, which would offer relative higher carry similar to some of these bonds, would be the Credit Risk Funds. Depending on risk appetite and understanding of the Credit Risks, the investors who have traditionally invested in these MLD bonds, could consider Credit  Risk Funds as an attractive and tax-efficient alternative.

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