Three Debt Funds To Consider Now

2017 was a difficult year for fixed income markets. After having fallen nearly 275 basis points between 2014 and 2017, yields began to move up. In the past one year, the yield on the 10-year G-Sec have risen nearly 1% or 100 basis points, meaning that funds that were running with a modified duration of 8 years took an 8 per cent hit on their NAV's - in many instances, fully wiping out one-year accrual profits. The reasons for yields moving up were multiple. Here at home, a bank bailout and expectations of fiscal slippage contributed to the downslide; and globally, the rising oil prices resulted in worries about the trajectory of inflation and monetary policy. About ~4 percent of the CPI basket comprises of diesel, petrol, and LPG, and a US$ 10 per barrel increase in global crude prices could push up overall CPI inflation by 70-80bps. On the global front, the US Fed started raising rates aggressively, which led to further falls in local bond prices. 2018 didn't start off too well either. In the recent Union Budget, the government's decision to raise its fiscal deficit target sent yields spiralling even higher by another 20-30 bps.

The RBI, in its recent policy meet, sounded the alarm bells with respect to inflation. In the recent Union Budget, Finance minister Arun Jaitley set the fiscal deficit target for 2018-19 at 3.3% of the gross domestic product (GDP), to accommodate higher demand for expenditure - against the earlier target of 3%. "Apart from the direct impact on inflation, fiscal slippage has broader macro-financial implications, notably on economy-wide costs of borrowing which have already started to rise. This may feed into inflation," the Reserve Bank said.

A year or so ago, we adopted a largely 'low duration' stance towards recommending fixed income investment. The present scenario calls for a revisitation of that strategy.

The Case for Credit Opportunities Funds (COF's)
Most debt funds invest in instruments that are rated as AAA or above by rating agencies such as CRISIL, CARE or ICRA. On the other hand, COF's even invest into debt instruments that have a credit rating of below AAA and AA. These instruments carry higher coupons than AAA-rated instruments to compensate for this lower rating; however, many of them are very much investment grade, or even rating upgrade candidates. Apart from interest accruals, these funds also get benefit from an upgrade in the credit rating of underlying securities, which results in price appreciation. In the current scenario, where the Central Bank and the government are joinftly trying to address the problem of high debt from both corporate and banking perspectives, COF can be viewed as a window of opportunity - as improving credit ratings could lend a fillip to their NAV's.

The credit environment seems to be improving at the moment. This has largely happened on account of rising commodity prices, which have benefited steel and metal companies; and a buoyant primary market, which has allowed companies to successfully deleverage their balance sheets in recent times. With corporate earnings expected to pick up after an extended lull, we're likely to see balance sheets getting cleaner, resulting in an increased upgrades-to-downgrades ratio in the medium term.

ICICI Prudential Regular Savings Fund, with a predominantly AA rated portfolio (56%), is ideally poised to gain from such an uptick in the credit rating cycle. Currently, the fund has a high YTM of 9.81%, and a low modified duration of less than 2 years - and therefore, it is by and large insulated against any further yield spikes. Even after factoring in a 1% mark to market portfolio loss on account of downgrades, we can expect the fund to deliver returns of close to 9% per annum on a 1-year basis. This fund should form the core of an investor's lump sum debt portfolio right now. Low risk takers with a time horizon of 12 months or more may invest lump sums into this fund.

More savvy investors can start locking into current yields 
With the gap between the 10-year G Sec and the repo widening to 150 bps plus, its fair to say that a lot of negatives are already priced into current yields (7.5% plus). In fact, the bond market seems to be pricing in not one, but two rate hikes by the RBI! The second half of 2018 should see a lot more clarity on global interest rates, the future of crude prices and other macro factors.

UTI Bond Fund, with its balanced YTM of 7.97% and modified duration of 4.42 years, seems well poised to capitalise on any falls in yields that may arise from positive macro news flows - such as a good monsoon, or controlled CPI inflation, over the next 18-24 months. Hence, we have replaced UTI Short Term Income Fund with this fund in our whitelist. Do bear in mind that yields may remain volatile for the next few months, and hence investors are not advised to overexpose themselves to duration. Investors can allocate between 20% and 30% of their fixed income portfolios to this fund, in a systematic manner via SIP's or STP's. Preferably, the target investment should be staggered over 12 - 15 months.

SBI Dynamic Bond Fund is a dynamic bond fund worth considering, if you're willing to take on the fund manager risk (not many fund managers have been too adept at predicting interest rate cycles of late!) The fund dynamically adjusts portfolio modified duration in a wide band (as low as 2.95 and as high as 7.97 in the past 12 months alone). It is ideally suited for investors with a time horizon of 2 years and above, and who understand that debt market returns may fluctuate in a 5% to 10%. Investors in SBI Dynamic Bond Fund must be made aware of the fact that their returns will depend upon the astuteness of the fund manager in predicting interest rate cycles and bond yields.

To sum up: it's time to look beyond accrual/ income funds now. Credit Opportunities Funds should form the core of fixed income portfolios (50%-70%), with the remaining being allocated to Long Term Debt (staggered) and Dynamic Debt (Lump Sums). Investors should be made aware of the importance of debt funds in their overall asset allocation. Blindly pushing moneys into equity/ equity-oriented funds is a practice that needs to come to an end. Judicious and well-planned asset allocation will drive portfolio returns over the next 18 months.