1995-2005: A period of duration play, high returns
In the first phase of debt funds, broadly between 1995 and 2005, fund houses launched fixed income schemes and tried to popularise them with both the institutional and the retail segments of investors. Between 2000 and 2004, interest rates in India fell by a significant magnitude, falling from 11% to almost 5%, at a pace of almost 150 basis points annually on an average. The resultant rise in bond prices helped debt funds to generate annual post expense returns of 14-15% for four to five years in a row. It was a period of duration play. Fund managers took high interest rate risk and were rewarded in due course if they were able to withstand the intermittent volatility by staying invested. There were tax benefits as well and investors gained from investing in mutual fund debt schemes, setting expectations high for the next phase as well. The popular funds in this phase were liquid, short term, income and Government securities funds.2005-2014: A period of experimentation, with mixed results
A period of high returns set the stage for elevated return expectations and a refusal to accept the changing reality. Interest rates that had been benign started to edge up, decisively. Income funds that were the poster boys of the previous phase delivered low to negative returns. Investors who had the mandate to take equity exposure turned to hybrid funds, debt funds with modest exposure to equities, and continued to earn marginally better returns on back of positive performance by equities. Investors who had to stay invested in pure debt funds tried their luck by investing in floating rate funds and variants of liquid funds like overnight funds, ultra-short term funds, low duration funds, money market funds etc.
The more adventurous investors found comfort in credit funds, a debt fund that invested in low rated, high yield bonds issued by companies with low ratings. Fixed income investing for fund managers became more complicated. In search of yield, investments were made in securitised pools of retail loans originated by banks and NBFCs, exotic floating rate instruments linked to a variety of market linked benchmarks and such other instruments in which the issuer and investment bankers made merry at the cost of the mutual fund investor.
Debt funds also resorted to dividend stripping, bonus stripping in an attempt to provide the corporate investors a post-tax return commensurate with the previous golden period of 1995-2005. The result was a larger number of schemes with no clearly defined risk-reward payoff and an experience that left the investor more confused about debt schemes than before. The funds that emerged were clones of short term funds like banking & PSU debt fund, corporate bond fund, credit fund and a host of hybrid funds like balanced advantage funds and equity savings funds.
2015-present day 2023: Emergence of the passive schemes-the fund manager resigns
The chase for yield resulted in fund manager fatigue. The fund management turned passive while the regulator turned active. Increased changes in policy from global central banks to avoid economic slowdown and inflation resulted in shorter interest rate cycles and sharper fluctuation in bond prices. A few high-rated issuers and numerous low-rated corporate issuers chose to default on their obligations leading to heavy losses for debt schemes and fund houses who had taken exposure to low credit papers in an attempt to shore up portfolio yields. Interest rate bets did not pay off as well as global volatility in inflation and yields resulted in an uneven experience for the Indian debt investor who had assumed high smooth returns as a given.
Amid the volatility, emerged a new brand of unlikely heroes – the fund managers who did not manage funds actively but chose to buy bonds and do nothing – the passives. Investors, in order to avoid volatility, flocked to the passives who let the portfolio slowly mature, while allowing the investor some tax benefit as well. Enter the regulator, who removed the tax benefit from debt funds as a whole due to the blatant violation of the spirit of the tax benefit. The regulator also came out with a spate of measures forcing fund houses to measure and mitigate risk more seriously. Debt schemes are now safer investment vehicles with well-defined risk parameters such as credit quality and portfolio liquidity.
The size of debt funds have grown multi-fold over the years. It is our hope that we are now entering a mature phase, and that major lessons have been learnt by investors, fund managers and regulators. In the next decade, we could see the co-existence of passive as well as active funds, high quality as well as credit funds and liquid as well as duration funds – which will combine in an optimal way to provide the investor a risk adjusted return from a portfolio of fixed income funds. The penetration of mutual funds in India is still far lower than other developed countries and in the coming years, the fixed income funds could emerge as the top choice for savers as well as investors.
(Sandeep Bagla is CEO of Trust Mutual Fund)
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