Bond yields have been dropping rapidly since the demonetization announcement. As a result, the NAV of long-term gilt mutual funds has been on the increase. At a time when many investors want to benefit from this move, Mr Srinivasan Sundarajan, in this third guest post, cautions to look before you leap.
About 10 days ago, SBI announced its decision to slash the interest rate for deposits, post the huge fund flow from the demonetization scheme. In fact, they published interest rates less than the Savings Bank deposit rate of 4% for bulk fixed deposits.
So people who prefer the safety of debt (and do not like the volatility of Equity) are wondering (and are being told) whether they should invest in Debt Mutual funds. Some of them are seeing numbers like 15% (annualized) return over a 3-year term in Long Term Gilt funds. At the other end, liquid funds are showing a return of 8% (annualized) over the same 3-year timeline.
When headlines and statistics are combined – you have a powerful cocktail; enticing, intoxicating when taken – but if you did not get it right you could have a bad hangover. (Pun intended)
Are you asking the right question?
One of the most important things to do is to ask the right question.
Let’s see how this dialogue progresses (between an Investor who is used to investing in FD and a Seller/ Advisor who is advocating Gilt Fund)
Q: Tell me where can I have the highest safety of my principal (at least like a bank)?
A: Well if you have invested directly or indirectly in Government of India bonds – you have the highest safety. So you should consider Gilt funds.
Q: My FD allows me to prematurely withdraw “any time”, with a little penalty. Will I have the same flexibility?
A: Of course, you can withdraw any time from your Gilt Fund. Some funds have a small period of penalty. Otherwise, you do not even have any penalty. In a couple of working days, the fund house will credit the proceeds to your account.
Q: I do not have TDS. (The bank collects my Form 15G/ 15H). What happens to that?
A: There’s no TDS. You do not need to provide Form 15G/ 15H either.
Q: What type of returns can I get from a Debt Gilt fund?
A: In the last 3 years, people who invested in Long Term Debt Gilt funds have made 13% – 15% annualized returns. In fact, those who entered even last year, have made more returns 15% – 18%. All this is happening when “all you have seen” is your FD rate falling. Further the person who invested 3 years ago – does not have to pay tax on the entire amount (gets indexation benefit as well!)
If you look at the above dialogue, it sounds very convincing to the investor that Long Term Debt Gilt funds are the way to go. They are invested in Government Bonds which carry no principal risk, have liquidity, no TDS, far better returns than FD. The investor thinks he was a fool to have not invested 3 years ago!
So, what is the issue then?
The Seller/ Advisor answered all the questions that the Investor asked. There was no falsehood in the statements either.
Now let’s look at the issues that were not addressed in the above questions.
- There is no TDS. However, if the Investor assumed that he could opt for a quarterly dividend – so that he can have some regular income, it’s going to attract significant Dividend Distribution Tax (28.33%). This is paid by the fund house directly. Where’s it paid from? Your fund’s earnings. [Of course, you can talk about SWP et al and optimise it.]
- There’s no principal risk with GOI bonds. That’s absolutely true. However, if the fund is invested in long duration government bonds – it’s extremely sensitive to interest rate change. In the last 2 years, we have seen interest rates go down, so these long-term bonds have appreciated in value. But when interest rates go up, you will see the bond value depreciate.
To help understand this better, I am going to source my data from Value Research Online (on 30th Nov 2016).
Let me take an example of a fund – SBI Magnum Gilt Fund – Long Term Plan [Note – you can pick any other fund, and you would have some similar finding. This is not an attempt to target this fund, by any means. It is used for illustrative purpose only.] to explain.
If you look at the aggregate portfolio data for this fund, there are a few fields – Modified Duration (years) – 6.76; Yield to Maturity% – 7.02.
I am not going to get into the technicalities of all the terms but will do my best to explain how to interpret this information.
A modified duration of 6.76 translates to a 6.76% increase in your NAV for every 1% drop in the interest rate. Let me try to see if I can explain it with this illustration – You have invested 100,000 today. Let us say tomorrow there’s a drop of 0.5% (half a percent) drop in the bond interest rate. This translates to an impact of 0.5% * 6.76 = 3.38% on your NAV. In other words, you 100,000 will now jump up in value to 103,380.
Now let us understand what the Yield to Maturity – 7.02% means. It means that with the current investments in this fund, it will generate a return of 7.02% every year. In layman’s term it is the equivalent of this fund earning 7,020 on a corpus of 100,000 in a year (assuming there’s no change to the underlying investment by the fund house).
Estimating first year return
Currently, a 10 Year Government bond averages about 6.25% yield. If you take the long-term history, the lowest yield it has reached has been about 5% for a brief period around 2004. It touched about 6% briefly in 2009.
So let us say if in the next one year the 10 year GOI bond yield drops from 6.25% to 5.50%. Now let us compute a possible return in such a scenario (note there are lots of approximation – so use this for illustrative purpose only)
Total returns = Impact due to Modified Duration + Interest Yield
Modified duration impact = (6.25% – 5.50%) * 6.76 ~ 5.00%
Interest yield ~ Average of Opening Interest and closing interest. (Assume closing interest will drop by the same 0.75% interest)
Interest yield = (7.02% + (7.02% – 0.75%))/2 ~ 6.65%
So, total returns = 5.00% + 6.65% = 11.65%
The fund has an expense ratio of 0.97%. [What this means is you will be paying about 1% of your money every year to the fund house to manage the fund.]
So after deducting the expense ratio, you can expect 11.65% – 0.97% ~ 10.65% return in the next year.
Estimating next year return
So, let’s continue from the prior year. The starting interest yield will be ~ 6.25% (7.02% – 0.75%).
Further, the 10 year GOI bond yield above was about 5.50%. It’s difficult to expect it to go any further lower given our inflation target is 4% +/- 2%. So let’s assume that the 10 year Government bond yield stays flat through the year.
There will be no impact due to Modified duration in this case. The interest yield is 6.25%. The expense ratio is 1.00% (approx.).
So, your return in the next year could be 0% + 6.25% – 1.00% = 5.25%
You will dread to think: what will happen if the interest rate starts to move up, again?
Findings from the illustration
The average return in the 3 prior years was 15.00% (every year) – way above the FD rates!
The next year could give you a return of 10.65% – still significantly above the FD rate.
The year after that could return 5.25% – going below the FD rate, now!
You don’t want to think what will happen if the 10 Year Bond rate starts to move up!
In other words, if the investor did not ask the right question about what will impact and how much is the likely impact on the returns – he is unlikely to get the full picture.
Further, the investor needs to understand that the principal does not have any risk, but the returns are highly sensitive from 15% – 10% – 5%.
As the returns drop lower, the impact of the expense ratio – is even higher!
Beware! Remember the famous statutory disclaimer of every fund – Past performance is not an indicator of future trends.
Understand your investing psychology – Why did you invest in FD so far? Is it because you were uncomfortable with volatility; is it because you knew that you will get some steady income (even though it may be low); it is because you felt assured of the principal. Will this new product appeal to you investing psychology?
If you are getting into long term gilt funds, you need to understand how it works – otherwise, you may become the captain of a sinking ship!
There could be arguments in favour of dynamic bond funds, income funds – which are also different types of debt funds. Well, they carry their own stories – which you need to understand.
So am I predicting anything in this post? The simple answer is NO! I am just attempting to share my knowledge with an effective illustration.
As always feel free to share your thoughts, comments and ideas.
These are the links to Mr Srinivasan’s other guest posts:
How to choose debt mutual funds with no credit risk and low volatility
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