“A rising tide lifts all boats. An ebbing tide tells us who was swimming naked!”
Taking on risk is a core part of investing. The Capital Market Line (CML) suggests, rightly, that the more risk you assume, the greater return you can expect. Hence, a venture capital investment would carry a much higher risk than an equity mutual fund that invests in public equities but would carry a correspondingly higher expected return. Similarly, within equity mutual funds, a small-cap fund would have a higher risk (and return) profile than an index fund tied to, say, the Nifty 50, and so on. Mismatches and wipeouts occur when investors assume greater risk for a given level of expected returns, knowingly or otherwise, and this is the balancing act that investors and fund managers undertake routinely.
Low duration funds (LDFs)
Let us look at an investment option that is way down on the risk (and return scale) – LDFs. Duration, for bonds, refers to a way of measuring how much bond prices can be expected to change when interest rates move either way (remember that interest rates and bond prices are inversely proportional, i.e., bond prices rise when interest rates fall). In this way, a bond’s duration may be understood to be a measurement of interest rate risk. Bond investors typically look at the duration of a debt instrument or a debt portfolio (a portfolio’s duration is nothing but the weighted average duration of all its constituents) to determine the riskiness of the investment. Simply put, a high duration security is high risk since it is more exposed to interest rate risk due to its longer maturity and thus ought to offer a higher return if the CML holds. LDFs invest in shorter duration securities – as per SEBI guidelines, the duration is restricted to between 6-12 months. While some part of the portfolio may be invested into longer duration securities, the portfolio should be within 6-12 months on average. This makes LDFs ideal low-risk options for investors looking to park surplus funds for a few days or weeks (LDFs provide a higher yield than bank FDs and may even be more tax-efficient, depending on the investor category) who cannot afford price volatility.
Debt mutual funds’ love for duration
G-secs (or Government Securities) are important in most debt mutual fund portfolios. In the view of the fund manager, these are risk-free securities held in a proportion that positions the portfolio to gain in response to how interest rates are moving. This is because G-secs are highly liquid and sensitive to yield changes. On Government Floating Rate Bonds (or G-sec floaters), the interest or coupon rate changes periodically (every 6 months), and these have lately been gaining popularity. With their popularity, mutual funds have been loading upon them – in the last year, with the specter of rising interest rates in response to US Fed action and rising inflation, mutual funds thought of G-sec floaters as a way to hedge portfolios against the impending rise in interest rates. How do G-sec floaters help? Since the interest rate resets every 6 months, these floaters do not fall in price as much as fixed-rate G-secs when interest rates go up because the reset will happen at the new and higher benchmark rate. This makes them an ideal offset in the scenario where mark-to-market (MTM) losses mount with increase in yields. So far, so good.
However, even too much of a good thing can be bad, as anyone knows. As is the wont of fund managers, they overindulged to the extent of turning the hedge into a speculative position, thereby ramping up risk.
Loading up on G-sec floaters
Mutual funds have made two big mistakes in their attempt to hedge (or speculate on) rising interest rates:
1) Loaded up too heavily on G-sec floaters
2) Took exposure to G-sec floaters in LDFs, which typically should not have maturity above 1 year (regulatory requirement of Macaulay Duration less than 1 year).
Normally fund managers have been very careful in managing LDFs and have refrained from exposure to any security with maturity over 3 years. Lately though, fund managers have gone ahead and loaded up 12-13 year G-sec floaters in their LDFs to position the portfolio for rising interest rates. But didn’t I also say they are not allowed to load up beyond 1-year duration securities, much less 12-13 year G-sec floaters!? The fund managers use a loophole wherein the duration of such G-Sec floaters is construed as 6 months (when the rates reset), making them kosher for LDFs.
Loading up on risk
The price volatility seen in these floaters over the last 15 months is to the tune of Rs 4-6, which suggests that they are being traded in the market very much like the 12-13 year bonds that they are and certainly not as 6-month bonds! To put things in perspective, in these 15 months, actual fixed rate 6-month bonds have traded in a band of 0.25-0.30% yield variation, whereas a Rs 4-6 movement in price (as seen with 12-13 year G-sec floaters) translates into a change in yield of 10-12% for a 6-month bond! Thus, prices of these floaters have traded in a band of Rs 96.5-102.5 in the last 15-18 months, which is a clear reflection of the risk these instruments carry, which in turn is a clear indication of their unsuitability for LDF portfolios.
Under various schemes, mutual funds have invested almost Rs 50,000 Crs in long-term G-sec floaters. One bank promoted fund house’s LDF has more than 30% of its portfolio in G-Sec floaters and of that more than 25% in long-term exposure beyond 5-6 years, up to 13 years. This effectively means that the scheme has more than 5 years of maturity! Similarly, many large fund houses have invested in these long-term G-sec floaters in their LDFs in anticipation of making quick gains, thus adding undue risks and exposing investors to highly volatile instruments. Here is a snapshot of just a few LDFs and their love for long-term G-sec floaters:
| As of 31 Dec 2021 | |
| Scheme Name | Percentage of Total Assets |
| Aditya Birla SL Low Duration Fund | 3.70% |
| Axis Treasury Advantage Fund | 3.47% |
| HDFC Low Duration Fund | 6.56% |
| ICICI Prudential Savings Fund | 40.21% |
| Kotak Low Duration Fund | 13.51% |
| SBI Magnum Low Duration Fund | 8.74% |
Source: Fund house portfolio disclosures
This build-up has happened over the last 12 months. As rate hikes loomed in the face of record government borrowings, rising inflation, and expected US Fed actions, funds built exposure to floaters, which then gave MTM gains and thus better returns, which attracted more funds, which meant more flow into floaters to maintain proportions, which pumped up their prices, which…and thus was born an (in)virtuous cycle that looked like it will never end!
Until it ended
NAV gains in such LDFs came from the long maturity of the fund, which had a high spread duration creating MTM gains from spread compression. The CML is the only reality and it says there are no free lunches in the market – the higher returns come from higher risk and no other factor. That too would be fine, except that an LDF investor is NOT looking for such risk, as already stated.
RBI has now indicated a slower pace of rate hikes on the back of improved government receipts, optimism over economic growth, and rising geopolitical uncertainties. This means too many variables are at play, and a high-risk bet on interest rates (especially in LDFs) may prove foolhardy. The spreads have expanded and the cycle will likely reverse. Moreover, corporate floater issuances have climbed significantly lately – the proportion of floaters in total bond issuance has moved from 1% pre-2020 to as much as 5-7% now. These issuers obviously have a strong view that interest rates will fall. Why else would they prefer to issue floaters!?
Implications
If the cycle does reverse, then, as explained, LDFs may be staring at large NAV falls. Losses are always bad, but this is most troublesome for four reasons:
- LDF investors have no appetite for such losses (I know, I am labouring this point, but it is important to re-emphasise)
- More problematically, sophisticated investors who are more attuned to the cycle and are aware of implications will pull out earlier, leaving smaller investors holding the bill
- The situation will likely create a run on the fund leading to more forced selling and more losses, which necessitates more selling to meet redemptions, and more losses, and more pull-outs, and more concentration risk, and…this is the same situation we saw with Franklin Templeton’s six schemes in April 2020, which forced the fund house to close down the funds.
- Points 2 and 3 above have a larger implication, also referenced to the Franklin Templeton schemes – remember that large institutional investors and even some senior fund executives pulled out significant sums just before the funds closed down.
This goes back to perpetual bonds, which were once a favourite of LDFs until SEBI stepped in to protect investor interest (imagine an LDF with a mandated Macaulay Duration of 1 year happily investing in a 100-year bond!), effectively barring them from holding such bonds in their portfolios.
SEBI did not come out smelling of roses in the Franklin Templeton saga but redeemed itself somewhat in June 2021 with its two orders imposing penalties and restrictions on the fund house, heralding a new direction.
This time, can SEBI please not wait for the ticking time-bomb in LDFs to go off before acting?
fiscalujval 