Zerodha Educate: Why are debt NAVs falling?

One topic we keep talking about on the podcast is debt funds. As we’ve alluded to numerous times in the show, most investors focus too much on the equity part of their portfolio and ignore the debt part. They often take debt for granted and invest based on recommendations or based on whatever partial understanding they have. This often ends up backfiring whenever there are bad phases in the debt markets like the IL&FS, DHFL, and Franklin episodes.

The other risk that investors don’t pay much attention to is the interest rate risk. Rising interest rates are bad for debt funds, and falling rates are good for debt funds. Given the strong inflationary pressures, RBI has hiked interest twice over the last month, and that has led to the debt fund NAVs falling. Predictably, over the last 3 odd months, the most common query from mutual fund investors was, “why are my debt fund NAVs falling?.”

So we caught up with Mahendra Jajoo, the CIO of Fixed income Mirae Asset India. In this conversation, Mahendra talks about:

  1. What’s happening in the debt markets
  2. Why are debt fund NAVs falling
  3. Why are interest rates rising
  4. What’s causing inflation?
  5. Why have debt in your portfolio?
  6. How should investors invest in a rising rate environment
  7. Tips on building a debt portfolio and much more

Podcast link:

(5:40) What’s happening in the debt markets

(12:35) Why have debt in your portfolio?

(15:47) Why are debt fund NAVs falling

(21:00) Why are interest rates rising

(31:50) What’s causing inflation?

(38:00) How should investors invest in a rising rate environment

(46:00) Tips on building a debt portfolio and much more

(52:50) Mahendra’s investment philosophy

Podcast Transcript:

Bhuvan: So Mahendra, thank you so much for doing this. The reason why we have you on today is because the debt market have suddenly become more action-packed than the equity markets and a lot seems to be happening along with the equity market. So people have a lot of questions on that, and so we thought we’d get somebody who knows what’s happening in the markets to give a little bit of context. But before we get started, why don’t you tell us who you are, and what you do at Mirae?

Mahendra: First of all greetings to everyone. My name is Mahendra Jajoo and I’m the CIO Fixed Income for the debt products at Mirae Asset Investment Managers. I have been in the market for close to 30 years now, plus couple of decades have spent in the debt markets. I’ve been associated with the debt markets from a very early stage in India. And debt mutual funds have now come up as a great option for the investors who are looking to invest in the debt markets. I am a chartered accountant and the company secretary and a CFA by education, and I have been for all of my career into the financial services industry.

Bhuvan: I just had a follow-up question, which is what something I asked a lot of these people, why debt? because debt is not as sexy or exciting as equity. It’s a little more sleepy compared to… but why the debt marketplace compared to going towards equities?

Mahendra: It’s a little bit of a glamorous side as far as the equity is concerned, but if you look at the country, it’s still a very large proportion of savings, the household savings, in particular, is into the debt markets. And then there are things that happen, you don’t necessarily choose everything in life.

I was actually part of the global markets in ICICI and then in ABN-AMRO. And therefore if you are aware of the institutional side or the banking side of the business, treasuries are fairly, I think, a highly glamorous job. And then ABN-AMRO floated the mutual fund in 2004 and they asked me to join the fixed income business.

I believe that the mutual funds are the future and everyone needs to do some job and fixed income is something which is very promising, it’s a very exciting and we have seen a great journey of the equity side of the mutual fund business in India, and I believe the debt sides time has come. And I feel pretty excited about this role.

Bhuvan: Through your career, you’ve pretty much been through the entire evolution of the Indian debt market, so to speak.

Mahendra: Yes. I mean, to be clear, I started my career in ‘92 when Dr. Manmohan Singh just unveiled the (cross talk)

Bhuvan: Ah, right at the interesting moment.

Mahendra: …reforms in India. So I can say that I’ve been associated from day one of the reforms story of India, and I’ve seen the days when debt markets used to have TDS for the government bonds and secondary market was next to non-existent and then from there on today we have a huge growth in the debt market.

So it has been an exciting journey. And from whatever I have learned during this period, from whatever observation I have, I think there is a huge potential in the debt markets and clearly, the tide is shifting from the conventional debt investment options to more exciting market related of debt. If I have to summarize the whole of changing the complexion of the debt investments in India, we are moving from fixed-rate products or from administered products to market-related products. And my belief is that market-related products always give you a better return profile and safety than the administered products. And mutual funds, debt mutual funds for example are market-related products, if markets go up, you get a different return and if markets go down, you get a different return.

The issue is that if you can deal with the volatility in the market, it gives you a very fantastic, perhaps the best return option. So it creates an option for you and that’s where I think that the debt mutual funds are said to grow further.

Bhuvan: Absolutely. That’s the whole thing. People move away from all those old-school products that they’re used to. So the next thing I actually wanted to do is set the context so that people have a sort of a base to understand the later part of the conversation.

So when you’re talking about debt markets we hear a lot of these fancy terminologies interest rate risk, credit rate, duration so on, so forth. So what are those 3-4 important things that investors should know, or 3-4 concepts they should know about so that they know what’s happening in the debt markets, they know what’s happening with the debt funds, and how to make sense of the daily fluctuations in the price. So just the basic concepts that people should know about.

Mahendra: Yeah. So again let’s say Zerodha is one of the most exciting developments that has happened in the markets recently and you guys have taken over this place, like no one else, and now you’re talking about debt. So I think there is some importance about the debt and then when it comes to debt, I think there is a lot of lack of appreciation of the some of the nuances of the debt business.

And then when I interact with the investors normally people say, look, when I want to learn about basics of debt, we want to understand what is duration, what is the conversity, how does the relationship between the yields and the price of a bond? Those are the technical side. I would say that there are those technical sides on the equity side as well. So you have the dividend discounting model, then you have the cash flow discounting and the cash flow projections, etc.

From an investor’s perspective, I would focus on three parts, the basics of debt investing that they must appreciate. Historically in India, investors in debt focus on safety of capital and then on the return. So the mindset that has been incubated in our psyche is that when you invest in debt, it could never be that the capital goes into negative. The fact of the markets is that markets are always going to be volatile and market offers an opportunity from time to time and people who understand the markets and why the volatilities there, can take advantage of that.

In particular, as far as the interest fixed up is concerned, interest rates are cyclical in nature. Classic interest rate cycle is that when there is high inflation, high demand or heating up the economy, the central banks would try to put a break so that there is no disruptive movements in the market. So interest rates tend to go up and then because of the central bank action, like the Fed is trying to do now by raising rates, they’re trying to control inflation. Eventually, the inflation will come down and then the Fed will again start easing rates. So this cycle is where the maximum opportunity is in debt. So if you just visualize that markets are going up and down, you have an opportunity to invest in an Instrument, which gives you a fixed predictable return or you can invest in a product that gets advantage from this volatility.

So, compare a classic bank fixed deposit with a bond fund, historically bond funds have given a higher return than a fixed deposit because bonds can benefit from the situation when the interest rates go up and when the investments made at the time, when the rates have gone up, when the rates come down, that gives capital gains also.

So, historically speaking, the debt mutual funds have given, especially the bond funds, which have longer duration paper higher return than the classic traditional products. The second advantage that the mutual funds have is the tax benefit because the more than three investments at this point, in debt mutual funds are eligible for long-term capital benefit, which is not available in any other debt product. So that’s a huge incentive because the tax rate difference can make a huge difference to your eventual return.

There is an element of credit risk because whatever investments you make, eventually, if the company to which you’ve lent money does not return it on time then that is a huge impact on your final return.

So, therefore, when you are investing in debt more than getting into the technical side of what is duration, what is conversely, which way interest rates are heading people should focus on three simple things. One, don’t be afraid of volatility. Try to take advantage of the volatility. How can you take advantage of the volatility is exactly how we take it in the equity side, do an SIP in a bond fund or invest for a full interest rate cycle. Interest rates go up and then they come down. So if you hold any fund form let’s say a 3 year period, which is typically a complete interest rate cycle, you will have a day when your actual returns will be higher than any target return and that is the day to review your investment.

Second is stick to high credit quality because if someone defaults, then all your return calculations are off the table, and third is invest for long-term, invest when a goal-oriented basis and be aware of the inflation because the returns have to be higher than the inflation for your purchasing power to remain intact and improve.

Interest rates are administered in most of the markets. They may not be administered in terms of the old times, but central banks do keep a very strict control on where the debt markets are and for the last 10, 15 years, the central banks have been extremely dovish in a number of cases the market rates are lower than the inflation level, which means the real interest rates as we call a negative, which means your purchasing power is depleting. So if you are investing, let’s say for 10 years, and you want to buy a house at the end of 10 years and put it in a bank deposit at 5% and if the house prices appreciate by 8%, then you will not be able to achieve your target.

So you need to invest in a way which beats the inflation in the asset class that you want to invest in for whatever purpose you are investing and for that you have to invest in a market-related product and which is where I think debt mutual funds come into play.

Bhuvan: Got it makes sense. Just to summarize, don’t worry about volatility stick to high-quality credit. So that means either G-Secs, state development bonds or triple A-rated papers and don’t do anything fancy and SIP works. Got it.

So the next question, I think it’s pretty much been on people’s mind is in the last few years we’ve seen phenomenal returns in the equity markets, markets have gone up 100-150% but what’s the point of investing in debt funds which are giving me 2%? So what role does, a debt fund play in my portfolio?

Mahendra: So theoretically speaking, if equity has given the highest return, then a hundred percent of the portfolio should be in equity, but then there are multiple reasons why people need to have a diversified portfolio, because if you put all your eggs in one basket and that basket for some reason goes wrong, then I think that the end result is not achieved.

The second is the risk appetite. Not everyone has the same risk appetite. Some people buy their build-up or construction are not very amiable to high volatility and high risk in the portfolio and then in a classic investing situation, people need to have a diversified portfolio.

Let me just give an example in March 2020, when COVID broke out, Nifty fell to 7,000 and that was like multi-year low. A lot of people would have panicked, people would have planned something. So if that time someone had invested in debt, then he could either have a better, stability in the portfolio or the most important thing is that point he could have used that debt money into averaging his investments in equity. But assume that someone was planning to go higher studies abroad and that happened on in that month, that plan would have got off the track. So I think the classic way to look at why to invest in debt or for that matter in gold or in property is to diversify your investments so that if there is an extraordinary development in one asset class, you get the protection because of the diversification.

The other is to reduce the overall standard division, which is the technical name for volatility in your portfolio. So I think just the return is one aspect of the investing. The overall purpose of investing is basically the two. One is to either create wealth for future or to invest for a particular objective. Both these can be achieved only if you have a diversified portfolio, putting all your eggs in one basket can lead to results, which are significantly different from the intentions.

Bhuvan: No, fair point. So that behavioural aspect of debt funds helping you stick through tough times and it’s highly underrated when people are looking at it purely from a returns perspective. So now to the question that has been on people’s minds, why are my NAVs falling for the last three, four months. What’s happening? Why are my debt funds negative? My debt funds are always supposed to go up. They’re not supposed to fall, what’s happening.

Mahendra: No, that’s what I was trying to emphasize that, look, if you invest in a debt mutual fund, these are market-related product and market prices change, markets change. So there is an inverse relationship between the price of a bond and the market use. So the interest rate go up the bond prices will fall and therefore the NAV can show a lower return or a negative return, depending on how big is the market movement. If you had on the other end, invested in a bank fixed deposit or fixed-rate bond, the value will not change in your books, but if you were to do the mark to market for the same bank fixed deposits this value on that particular day would have been different.

So let’s assume that you buy a mutual fund, which has a portfolio with a YTM of about 5% and then you invest in a bank fixed deposit, which also gives you a 5% return. Now, tomorrow, if they go to 6% because we marked to market the portfolio, the value of the bonds in my portfolio will be lower because of the application of the 6% discounting factor other than the 5% and therefore the NAV will be lower. The fixed deposit will be unchanged in the investor’s book, but if you were to revalue the cash flow of the fixed deposit for 5 to 6% it will show the same depreciation.

Now, what is the difference between the two; in case of a fixed deposit it’s locked-in but in case of a mutual fund, the fund manager has a pool of assets. On that day the rate goes to 6% somebody else may be investing in that fund or somebody maybe redeeming. The fund manager will be able to lock in some assets at 6% also. So overall the volatility that we see in the market going to eventually benefit the fund. We have seen so many examples where people panic and then redeem from the mutual fund. So if you look at the long-term history of the debt mutual funds. They have given a return, which is higher than the corresponding locked-in investments.

So the NAV has been coming down because markets are going up. Market rates are going up because the inflation across the world has moved higher. In US today the inflation is close to 9%. The Fed is hiking rates, so that is having the impact. But there are two ways to look at it. One is to panic and say, look, why my NAV has come down. That other is that look, this is creating an opportunity to invest at higher yields, fresh investments. So if I give you an analogy, that’s what we tell people, or that’s what we hear advisors say to investors that if equity markets are corrected, it is a good time to lockin fresh money (crosstalk).

So the other similarity, which I would like to say that in equities market also it doesn’t matter where the equity markets go if you invest in a stock, which collapses, then you get poor returns and which is why I emphasized the credit risk factor, that it doesn’t matter which way the interest rates go. If you invest, if you happen to invest in a company which defaults or which is not able to repay, then the returns will be very poor. So it is important to invest in a high-quality portfolio.

But the interest rate volatility is something that should not worry anyone. If you look at the most happening event right now in the market, the IPO of the LIC, this was the largest financial institutions in the country, and they are also amongst one of the largest debt investors in India. They are one institution with gives directed preference. So you see, they will keep investing when interest rates go up or go down they create a portfolio and therefore they are able to provide good returns to the administer.

So I think interest rate volatility is caused by multiple factors, primarily because of the inflation and the pace of economic activity. But that is something which the approach will be to take advantage of rather than feeling scared about.

Bhuvan: Got it. So just to be clear. So when RBI made the 40 basis points rate hike and we saw depending on across categories anywhere between half a percent to one half percent fall in NAV. So this was because interest rose up and that means NAVs fall down, but if an investor were to hold, throughout the interest rate cycle, that means he pretty much ended up on the right side.

Mahendra: Absolutely. I mean, look, this is not the first time that the RBI has hiked the rates.

Bhuvan: No, for all the people who came through in June, the new investors this is the first time I think are seeing the rate hike cycle. I think to some extent all these new investors might be a little panicked.

Mahendra: Not that I think is a fair point and they are right in panicking, but I don’t think panicking is a solution. I think when they have invested at that time also, I think it was well expected that the rates might go up or even if let’s say somebody invests today, knowing that the rates are going up. Is it the right thing to do? So we have something called the risk-return profile, and then we have the second thing, which is the risk profile of the investor. So if the interest rates have gone up, and the investors are panicking, they need to check whether their risk file is geared to handle this situation and as long as the risk profile is able to handle the situation. I think they will end up in a happy situation a few years down the line.

There are times when let’s say for example, right now, while the interest rates have gone up they are also expecting, a lot of people would also expect volatility in the equities market. Equities market have fallen 10, 15, 20% from the top in different markets or different stocks. So do you just clean up all your stocks or do you panic? No, the same analogy applies to the debt market because the interest rates have gone up and return may be negative for a few days. That’s not something to worry. As long as it is in line with your risk profile, in line with the objectives of the investment. But if somebody is taking an interest rate call that has gone wrong, you should exercise a stoploss or not. Those are the things, but I think we need to make a clear distinction between investors who are long-term in nature and who have the ability to withstand this periodic volatility episode they I think need not worry.

Bhuvan: Got it. So I have a really dumb question. Now that my NAVs have fallen, so you’re saying that if I just stick through, how long should I hold my debt fund before my NAVs break down? How would you answer this question?

Mahendra: Look we don’t know for how long this situation remains. The classic interest rates cycles are around three years and three years is when the tax benefit of long-term capital gain also kick in a debt mutual fund investment.

So first is that if the inflation continues to be high, interest rates will continue to go up and therefore the NAVs may remain negative for some time, they may actually fall more. Now we also discussed that interest rates are cyclical in nature for interest rates will go up and then they will come down. So when the interest rates are going up at, during the up cycle, I think the idea should be to keep on adding to your investments so that your average investment keeps going up and then when the interest rates peak and they start coming down, then you start enjoying the benefit of capital gains and therefore end up with good returns.

Now for how long the rates will go up, we don’t know because markets are unpredictable. I mean, if you look at the current situation, one can expect that interest rates will continue to be on an upward movement for the next one year or more. But will that be a reason to be panic or will that reason to not add, or will that be a reason to redeem? I think from our perspective as portfolio managers, from a long-term investor’s perspective, this should be considered as an opportunity to add to your investments at higher and higher rates, and then have patience for the interest rates cycles to turn.

Therefore, I think that rather than taking a call on how far or how longer can interest rates go higher it is better to take a call on how are, how am I to deal with this? Is it going to be a permanent loss for me? Or is it going to be an intermediate period of turbulence for me? So it’s like when you are on a flight and there is turbulence, do you think in terms of landing or crashing.

So I think from our perspective, these episodes are more like turbulence during a flight and we don’t worry too much about it for individual investors who don’t understand this, or who do not, who understand this, but are not able to emotionally digest that these challenges are there. We, of course, I will not discount the possibility of investors who might have taken a investment without understanding what its implification is. So for example, if someone has taken a opportunistic call he might’ve thought that interest rates at 7%, for example, looks good and now it has gone to 7.40 then I think because it is not, in fitment with his risk profile and the investment objective. So we need to make a distinction between investors who have come with a long horizon and understanding of what’s happening versus people who might have taken an opportunistic view.

Bhuvan: I really like the idea that you said so when the equity prices are falling, you are expected to go and buy the dip and buy the dip has been kind of the slogan for the past two years and investors are better off having the same mindset when it comes to debt funds also. So keep investing through SIPs according to your goals.

Mahendra: And the only thing is like in equity markets, Nifty might make a new high, but every stock may not, so the stock selection, here also the portfolio selection is very important. If you happen to invest in a poor-quality portfolio that may be a red flag, it’s important to maintain high-quality grade portfolio.

Bhuvan: Absolutely. I have a few follow-up questions on the portfolio part. But before that, like you mentioned, US Fed is in a rate hike cycle, they just did a 50 basis point hike. Bank of England, Japan, pretty much all of the developed markets, EM markets are in a rate hike cycle. So globally since that, we are in sort of synchronized rate hike cycle. How does this affect the idea? Does that mean all these pressures will also ensure that we remain in a rate hike cycle for the foreseeable future without putting a start and engage to the cycle?

Mahendra: Absolutely. No doubt about that because see India today is so well integrated with the global market. So that is one reason, the primary reason why we cannot be immune to the global developments is that India is a country by construct having a large current account deficit, which is in a simple language “our imports are far more than our exports”. And then we have software exports, et cetera, et cetera, if you put them all together also, goods and services put together our imports are more than the exports. Therefore we need to have foreign capital every year to balance our currency balance of payment account. So if we stop getting FPI money or the FDI money or foreign capital in some way, then that will lead to currency depreciation that will lead to higher inflation because of the higher cost of import and so on.

And therefore, historically, if you look back to the past, whether it was in 1999 or 2003 or 2008, or in 2013, the periods of maximum turbulence in our markets, including in fixed income markets have been when the global markets have been turbulent or they have gone into a disruptive mode. In COVID situation also, we had the same situation, what has happened, over a period of time that India and the economy has been growing and the composition of our economy has also been moving towards higher value-added products and therefore we have been getting a lot of the FDI and that has been able to give us a good speed. Our Forex reserves are now $600 billion plus, but we still need that capital.

If the global investors stop investing in our markets, then there will be challenges. Now, why would they stop investing in our markets can be for two reasons. One is that if India has a problem, so today India has no problem, we are a economy where everybody’s looking to invest and expects good results, but there can be other challenges in their home market. Suppose if, because the Fed is hiking rates if the FPIs were to invest in India their investors would start redeeming then they need to take the money out of the country. So we have historically seen a huge uproar from the emerging markets when the Fed is tackling liquidity and that could compel inturn FPIs to redeem.

If let’s say for example, and that’s, what was the narrative in the market. If the global interest rates are going up and RBI is not hiking rates and the interest rate differentials become too high. Investors from overseas may be tempted to take the money back to other markets which are more attractive. So there are multiple reasons. Regularly bring our dependence on the foreign capital and the fact that the FPIs are already such a large part of our market on the equity side and also on the debt side if they decide to take out the money because they don’t like the domestic setup for whatever reason, then, then that can cause a big problem.

And therefore we cannot be immune to the global developments, including the global monetary policy setup or the global infrastructure cycle and therefore I think that with the lag the overall direction for our markets will be similar to what’s happening in the global markets. Therefore, just to conclude if Fed is continuously going to higher rates I don’t think we can skip that. We’ll have to also be part of the same system.

Bhuvan: From your vantage point. So we are seeing inflationary pressures across the board, not just in India, but across the globe. Do you guys have any sense of what’s causing this? Because up until 2019, they were okay, but then they had the lockdowns and then post the re-opening we have seen all sorts of issues from supply chain issues, shortage of gold, shortage of labour, so on and so forth.

Like, is this purely like a supply-driven phenomenon or is it both supply and demand? Because demand is also pretty much solid across the board.

Mahendra: So in my view, the supply chain, disruption is one factor which is causing inflation. There are two very important other factors. One is that you will see that inflation has primarily come in the developed market. So you look at US, Europe. I mean, Europe is the economy, which is so sluggish, but it’s still now close to 8% inflation. Countries like Australia, which are commodity exporters they don’t need to have inflation they should be very prosperous, but in the COVID period, the Western governments undertook a huge fiscal expansion program. So in 2020 and 21, most of the Western governments incurred 10-15% of the GDP fiscal deficit. Now, where did that money go? That money went into supplementing the salary income loss of the individuals, that money went to the small and medium enterprises who continued to pay salary and not fire their employees. That money went into rent replacement or rent supplement checks to people who were otherwise going to be vacated from their house for their inability to pay rent. So the paralyzing of the economy due to COVID, at least in the early phase, led to huge spending by the governments and that money came in the form of demand in the coming months.

So that is one. Now we look at 2008 to 2019 most of the global central banks had done huge monetary accommodation, but that did not result in inflation because that money did not get absorbed in the broader economy, there was no spending and that liquidity always remained parked with the central bank’s reserves. So that is one factor. Therefore, if you see the moment COVID broke out in 2019, first, the inflation in global markets came down and then the inflation phenomenon started happening around early 2021. So it’s the last ones in US the inflation was around 1.5% in January ‘21, now is at 10%.

The second reason I think inflation has come back is because of this extra liquidity that the central banks let go, let remain in the system, the commodity prices took off and we had one of the strongest commodities bull market in the last one and a half months, we had aluminium steel, everything go very, very high. And then I’ll just give you a little bit of insight into where the supply chain disruption comes.

The supply chain disruption became a serious issue in the second COVID wave, because if you recall, February, March, April ‘21, when the second wave was there, May, that was the time when the US and the other western markets like Germany, et cetera, were beginning to open up because they had the threshold approaching for the vaccinations et cetera, and the COVID cases had begun to ease out. So they started to open up, but that was the time when some of the Southeast Asian countries like Vietnam, Philippines, Malaysia, Thailand they had their worst outbreak of COVID, at that time in ‘19, they did not suffer as much as in ‘21. So you have a situation where the Western economies are opening up, which are the biggest importers from these countries and these countries were shutting down. So there was a huge supply chain disruption.

And that’s why you see that in the second wave while India was a big sufferer, the industrial companies continued to operate even through the Covid two lockdown, which is why our export suddenly took off. So our exports have been coming down and we’re very sluggish for last five years, but in last one year, our exports grew at a very rapid pace, 40-50% and we touched 40 billions of exports last month, which is the highest ever that we have done.

Suddenly the complexion, India was a big beneficiary of those countries closing down and then that supply chain disruption had continued, and finally, in the last couple of months, we had the fresh disruption due to the conflict between Russia and Ukraine. Now, those are the two countries which supply a large part of the food items, like wheat, et cetera to the rest of the world. So even if the dispute is resolved today, Ukraine will not be able to harvest the wheat crop and therefore this disruption is likely to continue. And this discipline is now affecting not only the other items but the basic necessity. So food chain is disrupted, then Russia manufactures some of the important chemicals required for fertilizers and then Russia is one of the largest exporters of petroleum and gas. The core basics of life, food, fertilizers and energy has been challenged.

And therefore, now the expectation is that inflation will remain elevated for a while and which is why we are now seeing a synchronized rate hikes cycle led by this inflation at the moment.

Bhuvan: The world suddenly seems like much scarier place than it was just two years ago. Just shifting gears, I just want to pick your brain a little bit about how investors should go about investing in such a rate hike cycle.

So now that we are firmly in a synchronized rate hike cycle as you mentioned. So what should investors do and more importantly, what shouldn’t they do in a rising rate environment?

Mahendra: I think the first thing that investors need to do is to understand their risk profile and the objective for investment. Like I said, I mean, it’s something like, if you ever fly during the monsoon times. I’ll go back to my favourite analogy, it happened once, we had a flight which was highly turbulent flight. So once the flight landed, everyone was very relaxed, finally the turbulence is over and then on the way out of the plane, I just happened to say hi to the pilot and then I said, how do you feel? He said I’m just preparing for my return flight on the same route.

We as portfolio manager in a debt market, we are used to this volatility and we are not scared of it. We know where this is an opportunity and where this is a reason to be cautious. So that way, like the pilot is not only not bothered about the turbulence, is preparing for the return fight with the next batch of passengers. For us one investor will redeem, another will come. Will either be panicking or not having the risk profile for this environment. So I think it’s very important, I tried to make it a little light, but I think it’s very important to understand the risk profile.

From my perspective, this interest rate hike cycle is just about starting. So maybe people should take a little cautious view and invest in short-duration funds. So invest in funds like ultra short-term fund or low duration fund, which typically have one to three years of maturity. There is a lot of protection there even if the rates go up, a lot of papers will mature in the next six to nine months and fund managers will be able to invest at a higher rate. So I normally divide the investors in three categories, investors who do not have the risk appetite and who do not have the investment horizon, they should stick to the liquid funds, ultra short-term fund or the low duration fund so that they have a reasonable confidence about the good return without too much of volatility.

Then their second set of investors who are long-term in nature and who will have recurring surplus to invest, it can actually go in SIP mode so they should not even look at the markets on a daily basis. They should remain invested and they should continue to add as the rates go up because the interest rates are cyclical in nature and therefore once the cycle is complete and then it starts ease again. They will see very good results. I just give an example of 2018 to 2019. The interest rates went up from 6% in 2017 to around 9% in 2019 and then they came back to 6% in 2020. So the people who invested during that phase made 10% plus return. The people who got out somewhere got different results. So what I’m, again, trying to emphasize interest rates are cyclical in nature.

Now, what is the risk that interest rates continue to go up and then you’re coming down? That can happen. So you can take example of many countries which actually defaulted and so on and so forth, but India is the country which is fundamentally still showing a lot of improvement. India’s fundamentals remain strong. So therefore this is a season where the inflation is high because of different factors and the center banks are coming from a situation of having taken the interest rates to a very low level because of the COVID disruption. So the early phase of the tightening cycle is sounding a little bit fast paces but then that also creates an opportunity for the new investors. So just to summarize people who have a structural allocation to fixed income, they should remain invested, not worry too much about the market movement, except that they should focus on high quality portfolio, not get lured by higher deals on weaker credit quality papers.

People who have no appetite or who are very short, they don’t want any thing but a fixed return can look at the shorter-term one. Then you have people who are investing based on the market view or based on their understanding, or they want to take a technical call, for them I think right now, clearly the interest rates are hitting higher in my view and therefore right now they need to have a pause and wait for a better market environment to start investing.

Bhuvan: Got it. To your point about people sticking, the need for people to stick to lower duration funds. So this is general advice in the market, that if you don’t know what you’re doing, if you don’t know much about debt funds or if you don’t have the ability to take tactical calls, can short-term funds become the core part of your allocation, regardless of the interest rate cycle, and just continue to invest in them no matter what happens with the interest rates?

Mahendra: Absolutely, just look at the last 25 years, what has not happened in the last 25 years. The change of government, we had the social instability, we had the rating downgrade and we had a recession and we had the global financial market crisis and what is the result of the last 25 years? 25 years back, interest rates were 15% in India and now they’re in the region of 6 to 8%. Why that has happened is because India’s economic strength and fundamentals have continued to improve. If that continues to happen, the interest rates will move in the inverse direction and eventually come down.

The second is that we had so many episodes of turbulence in the fund industry. What has happened is that some fund houses have gone out, some funds have closed, but the fund those survive have given returns, which are very attractive from a long-term perspective. So the longer you look at the history, that is a guide, you see that ultimately the people who had the staying power and the right choice of the investment survived. If the only difference between someone who’s a billionaire today, and someone who is a pauper is whether in ‘99 he chose to retain his holdings of Infosys or (crosstalk). So, which is why I put so much focus on having high-quality portfolio.

So if you just make the right choice, then I think the market volatility is not something to worry about. So you choose any fund, but if you are going to invest for a long term then you want to be rewarded for being a long-term investor. Before you will put money in bond funds because they have the potential to give you the highest return in the long run.

Bhuvan: Following up on that point, let’s say, for example, I’m somebody who is 25 or 30 and I have some additional surplus so that I can invest every month in whatever debt fund. But the problem today is there are 16 categories of debt funds. That’s just a nightmare for most people. Are there any rules of thumb or like basic guidelines so that most investors who just want to invest monthly and forget about everything else because they don’t want to take interest rate calls, they don’t want to do all this fancy tactical stuff. Are there any categories and are there any categories that they can straightaway ignore and are there any categories that five, or six categories that should be part of their screening process?

Mahendra: I think that’s a very good question because that is one area where we keep on getting a lot of questions. Like how do I choose which categories to choose? It is important to understand why there are 16 categories. Generally, the risk in the debt side is measured in terms of the age of the instruments. So the longer the instrument it’s supposed to carry higher risk and then the credit risk, because the poorer the credit quality, the higher the possibility that the company can default.

So there is a historical background to why do we have 16 categories because mutual fund industry has evolved over the last 25 years in doing this 10 different products were invented but then when the consolidation happened the funds were bifurcated in order of the maturity and then a couple of categories, which go by the credit rating. So I think the investors can probably define themselves again into three categories, short term, medium term, long term and I think you can pick one in each category.

I would say that if I’m an investor a short-term investor, I mean, basically transactional investor, I look at something like liquid fund or a low duration fund. So two funds in that category, and then somebody is in the medium horizon, then he can look at short-duration fund because short-duration funds have a regulatory obligation to maintain duration between one to three years. So they can’t be too much out of the market and they can’t be participating too aggressively in the market, that’s the safety that the regulations provide.

And then if somebody is a long-term investor, then you have a range of funds, corporate bond funds, Banking and PSU fund, the medium duration fund. I think if one picks up Banking and PSU debt fund then that addresses most of these areas. So he can cut the clutter and focus on these three and say, look, if I am short-term medium-term, long-term I’ll invest into this.

Bhuvan: I really love the framework. I think that should help investors get on that question of “Oh my god, there are 16 categories, I don’t know what to do”. That was really helpful.

Mahendra: I’ll tell you something, you just go to buy a TV, there are so many (crosstalk) each TV and one feature. So now you probably looked at the TV with the thing that I want to be 75 inches or 55 inches or 30 inches and then you have every little feature added on. Just go to a coffee shop, they’ll say basic coffee, coffee with extra cream, coffee with this. So there are these subtle variations in each part of the life that we get into and we have a very clear choice that this is what I want to do, I want a TV, I want this feature, there’s so much extra. So in debt funds also I think life is simple, there are so many funds with similar characteristics, just need to choose one.

I’ll tell you my guide is that there are funds at the long longer-term which have a maturity range defined by SEBI and then there are funds which are given the credit quality prescription. So I will choose a fund, which has a range for the duration. So as I said, why in the short-term duration, because 1, 2, 3. So you know, the bounds of how (crosstalk). Similarly, if you were to go to that site, you have a defined. So if you look at the Banking and PSU fund what we see that in the long-term, what is most important is the credit quality. So if it is a Banking and PSU debt fund, you’re largely investing in a highly regulated and protected sector. So the chances of things going wrong on the credit side on that are lower than in other segments of debt market.

And then they have largely a tilt towards the longer duration horizon, but they don’t have any jet prescriptions for when you’re investing in the long-term you want to maximize your return. So you want to give the flexibility to the fund manager to calibrate its portfolio in line with the interstate environment. So you will get the best results in my view, if this is how you choose. Now, there are so many similar-looking options, which can confuse you, but if your objective is clear, then I think this is how you need this one.

Bhuvan: Got it. I just had one final follow-up question on the credit part. I mean, you know better than anybody popularity of credit risk funds amongst retail investors, for all the wrong reasons. I personally am not a huge fan of that category for retail investors to begin with. Like is the best advice that retail investors should stay away from these credit risk funds, outright?

Mahendra: My personal view will be yes because again credit risk funds can be a good choice at a certain cycle of the market. Suppose when the credits are priced very defensively or the credit cycle has kind of come to a bottom. So you look at last one and a half year, post the ILFS crisis credit risk funds is one of the better performing. But those are more, I think, appropriate for sophisticated investors if you define retail investors to not necessarily have the understanding of the intricacies of the interest rate cycles and credit cycle, I would say, avoid. Again, if you look at the long-term track record, they have not given you the return commensurate with the extra risk profile.

Bhuvan: So that’s one point that people miss out on. The thing that higher risk leads to higher return, which hasn’t really played out, even if they are compared to let’s say, short-term funds.

Mahendra: In my view, given the fact that exposure to credit risk funds requires a far deeper understanding of the interest rate and credit cycle and the historical return profile does not justify the extra risk taken. I would say that for retail investors they can stay away from the credit risk funds.

Bhuvan: I hope people will take that point. I just had a few questions about you personally.

What’s your broad investment philosophy be it equities or be it debt? How do you look at this when you are investing here on when?

Mahendra: So professionally I invest in, of course, I mean, manage the debt funds and my philosophy is nothing different from what I have said over the last hour or so. I mean, I pretty much managed funds in line with the perspective fund mandate and regulations and within this framework of having an active management style with the focus on a high-quality portfolio.

When it comes to personal life, I’m like anyone else, like any other salaried and guided by the standard prescription. So I allocate my savings into equity, debt and other asset classes and I am a big fan of SIP investments because I think the best results come when you don’t look at your portfolio for 10 years. But knowing that the no individual stock will go wrong, so I personally feel for people who don’t have the sophistication of direct investing. Investing in equity mutual funds for me, that has been the (unclear audio) For all practical purposes majority of my investments are in mutual funds and different types and that has worked well for me.

Bhuvan: Got it. This is one question I ask whenever I’m speaking to people who have been in the industry for a long time. Over your investing career, be it with your own money, or through your professional investments. Is there any mistake that sort of stands out in your head that in hindsight, you should have done it differently or something like that? It need not be a mistake, something that broadly speaks out in terms of…

Mahendra: I think it may surprise you, or it may not surprise you, but I think there are two fundamental mistakes that I think I could have done differently. One is that early investing is very important. The day earn, you should start investing, always save some part of your income and then I think, one has to be very optimistic about the future. Every time there is a bout of volatility in the market, or we say, ye zyada ho gaya, ye kam ho gaya. I think I would say that my best outcomes have been where I have invested and forgot about it.

So I think that lesson to me has always been that “the more you want to time the market, then the chances are that the results will not be very good” and which is why I put so much focus on that. I find very funny is that people and based on the brains that I met, that they say when it comes to equity, please don’t time the market, timing in the market is much more important than timing the market. Don’t worry about the volatility in the market and then the same people when it comes to debt the first question is what is your interest rate given? I say it doesn’t matter if you are a long-time investor.

I think there is a huge dichotomy between how people look at equity and how people look at debt so far. I think that philosophy has to change and if anyone can time the market, I mean, just think about it 1990 to 2020, Nifty was at 7,000, I mean, if you can time the market, please do there. It’s funny.

I think people have to get over this thought process of their first reflex reaction is interest rates are going up, should I invest now or not, I say if you’re an investor the day-to-day market movement should not matter to you. The immediate outlook should not matter to you because we don’t really know what will happen. We should have an active approach that if things change if new developments happen, we change our strategy, so invest with a fund or a vehicle where they have a flexible approach to investing and let the professionals do the job that has worked well.

Bhuvan: Are there any books, movies that have shaped your thinking profoundly? Some must-read books for people who are listening to this?

Mahendra: Well, I don’t know. I mean, I’m not much of a movie fan, so there isn’t any particular movie per se, but I think there are some individuals in public life who motivates you and I think by naming one and not naming so many more… I get more inspiration from people in public life. One thing that has impressed me a lot about our country is that if you look at the top kind in any filed, whether it is Sachin Tendulkar in cricket, or whether it is people like Akshay Kumar or if you look at Narendra Modi, people in every sphere of our country have come from very humble backgrounds. So this country gives an opportunity in spite of all the perception or all thing, you look at that top guy in any field, you look at Mahendra Singh Dhoni, they are all from humble, humblest of the background and that I think is the reason to be extremely optimistic in our country. And also when those kinds of people come to the power or the position of prominence, which means that the rest of the country will also do well and therefore, I said we have to be more, more optimistic in life. So that was one mistake with which I made that I was not optimistic enough and not aggressive enough in investing in my early life. I think everyone should follow that.

Bhuvan: Thank you so much, Mahendra, for doing this. This is absolutely phenomenal. I personally learned a lot. I’m pretty sure everybody who will listen to this will have plenty of takeaways, not just with their investing but for other aspects of life as well. We really hope that we will get to have you sometime soon back on the show. Thank you so much for doing this.

Mahendra: Thank you so much for your time and inviting me today. Thank you so much.

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