With fixed income instruments offering attractive returns, find out how to build a strong debt portfolio These investments help counter the fluctuations of higher-risk assets, such as equities, providing a degree of stability to the portfolio. This shield can only work if the fixed income part of the portfolio is resilient to adversity. For this, having a proper mix of fixed income assets is critical
Investors in the fixed income space are currently spoilt for choice as the segment is offering attractive returns. Small finance bank fixed deposits (FD) are offering up to 9%. The RBI Floating Rate Bond now pays 8.05%. New online bond platforms are tempting investors to high-yield NCDs, offering a mouth-watering 11-13% per annum. This bonanza is sure to whet investors’ appetite, but it also presents a tricky scenario.We typically park our money in fixed income instruments for safety. These investments help counter the fluctuations of higher-risk assets, such as equities, providing a degree of stability to the portfolio. This shield can only work if the fixed income part of the portfolio is resilient to adversity. For this, having a proper mix of fixed income assets is critical. Diversification is not just for your equity portfolio. Fixed income investments can also vary widely in risk and returns.
Not all bonds and FDs are the same. Different products serve different purposes. That is why it is equally important to strive for diversification within your fixed income portfolio. In this week’s cover story, we outline a framework for building a safe, well diversified and, yet, potent fixed income portfolio. We also discuss how investors can safely navigate the high-yield, high-risk arena within fixed income.
BUILDING AN OPTIMISED FIXED INCOME PORTFOLIO
Return, liquidity and safety are key considerations while assessing any investment. Equity investors understandably seek to maximise returns, giving low priority to safety and liquidity. Equities are a wealth generating vehicle. It is, therefore, reasonable to optimise returns in this asset class. When investing in fixed income, priorities must be different. The primary role of fixed income is to preserve and protect your wealth.
It is not for asset building. Safety must be accorded top priority in such investing, insist experts. Girish Lathkar, Partner and Co-founder, Upwisery Private Wealth, asserts: “In fixed income, we are not psychologically used to losing money. That is why, safety is most important.” It provides assurance that our original investment amount will come back to us. This is more important now when attractive yields are in the offing. Higher yields are typically accompanied by higher risk.
Liquidity comes next in order of priority for fixed income investing. Your money may be in a safe place, but can you gain access to it whenever you want? Or will you incur a steep penalty to get it out? Liquidity is the ability to get your original investment amount as quickly as possible without incurring a hefty cost or penalty. The fickle nature of liquidity in bonds was painfully evident in the aftermath of the 2018 IL&FS default. Arihant Bardia, Founder and CIO, Valtrust, avers, “Unlike default risk, liquidity risk in bonds is not visible upfront.” The lower credit market, covering papers rated AA and beyond, remains particularly vulnerable to a liquidity squeeze.
Rates of some traditional savings instruments are elevated
Return should get its due only after safety and liquidity. Return and risk are two sides of the same coin. If you want a higher return, you need to take more risks. Anshul Gupta, Co-Founder and CIO, Wint Wealth, avers, “Most FDs are unable to beat inflation, yielding negative real returns. To match inflation, or even beat it, some risk needs to be taken by diversifying beyond FDs.” If you are averse to risk, you need to be comfortable with a lower return. The fixed income universe comes with a diverse range of risk-return options with their own safety and liquidity characteristics. With this framework as the backdrop, experts advise investors to create a bucket strategy within fixed income. Demarcate the entire portfolio into three distinct buckets, each serving a different purpose.
1.LIQUIDITY BUCKET
Every individual needs a money pot that can serve as a backstop during times of distress. This is the emergency corpus that will come to your rescue during specific events like a sudden job loss, prolonged illness or accident. Without this buffer, you would be forced to dip into the pool of investments meant for key life goals. A solid emergency fund is one that is easily accessible at a very short notice and is immune to value erosion. It is a job that is best left to fixed income. Ideally, up to six months’ worth of your household expenses must be parked in a mix of bank fixed deposits and liquid funds.
Small finance banks are offering attractive FD rates
While income from both now gets taxed at the slab rate, liquid funds are superior, given that gains on these are only taxable when redeemed. Interest income from FDs is taxable on an accrual basis. Further, breaking an FD usually attracts a small penalty in the form of lower interest rate for the current tenure. Money parked in a liquid fund can be withdrawn at any time in full without any penalty (except exit load if withdrawn within seven days). Depending on your needs, the emergency corpus should take up to 10% of your fixed income portfolio.
VARUN FATEHPURIA
FOUNDER AND CEO,DAULAT
“Make sure you understand the bond’s hierarchy within its issuer’s capital structure. While subordinated bonds yield 100-150 bps higher returns, it’s not worth the risk.”2.STABILITY BUCKET
This bucket is the core part of your fixed income portfolio, accounting for 70-80% of the assets. It must house investments that provide stability to the entire portfolio from the asset allocation perspective. It should also contain instruments that make a significant contribution towards key financial goals. Experts suggest carving the core fixed income bucket into distinct time buckets based on the maturity profile of investments—short, medium and long term. Investments of up to three-year time horizon should be in the short-term bucket. Any high-profile bank FD, top-quality NCD, short duration bond funds or corporate bond funds should find space here. Avoid high-yield small finance bank FDs, corporate FDs and NCDs rated AA or below for core allocation.
Corporate FDs are also fetching high returns
Bank deposits are safer than those with NBFCs because of their deposit insurance cover of up to Rs.5 lakh. The medium-term bucket would cater to cash-flow needs of over four to eight years. Locking into five-year FDs and NCDs makes sense now. Top-quality NBFCs are offering returns in excess of 8%. Rather than wait to catch the peak rates, it appears prudent to lock in now. Apart from these, target maturity funds of five-seven years’ tenure or mediumduration debt funds fit into this bucket. For those seeking assured regular payouts, the RBI Floating Rate Bond is a good option. It has a tenure of seven years, and the interest rate is reset every six months. Keep in mind that the interest income is taxable and there is no premature withdrawal option, except for senior citizens.
The long-term stability bucket will cover instruments with a long lock-in period or maturity profile. The Employee Provident Fund (EPF) and Public Provident Fund (PPF) would feature prominently in this bucket. The guaranteed return, along with EEE tax exemption status, at all three levels—contribution, interest payout and maturity— make these the best vehicles for this bucket. Parents of a girl child can also take the benefit of Sukanya Samriddhi Yojana, which also fetches guaranteed returns (currently 8%) along with the EEE taxation status.
ANSHUL GUPTA
CO-FOUNDER AND CIO,WINT WEALTH
“Most FDs are unable to beat inflation, yielding negative real returns. Some risk needs to be taken by diversifying beyond FDs.” The account can be closed after 21 years or on the marriage of the girl, whichever is earlier. Half of the accumulated corpus can be withdrawn for the girl’s higher education needs at 18 years of age. As a rule, do not venture into high-yield (credit risk) or duration strategies (interest rate risk) for the stability bucket. Also, stay away from annuity products, as well as guaranteed return plans offered by insurers. These mostly offer poor returns.
3.TACTICAL BUCKET
This bucket represents the opportunistic part of your fixed income portfolio. The idea of any tactical allocation is to play the credit cycle or take advantage of interest rate swings to give a boost to the overall portfolio. For this bucket, you may target investments in high-yield NCDs or gilt and long-duration funds. FDs of small finance banks can also be tapped here. This bucket is not for everyone, and can even be skipped altogether. It is only advisable if there is enough surplus left after allocation to the earlier two buckets. Further, only those with adequate understanding of the economic cycles and nature of different risks in bond market should venture into this territory. Tactical exposure is best limited to 20% of the overall fixed income portfolio.
AA and lower rated bonds are trading at high yields
The spreads over government securities and AAA-rated bonds are attractive.
The recent spike in bond yields presents a good opportunity for debt investors to lock into 10-year constant maturity gilt funds. These work best when rates are closer to the top of a rising cycle. By simply owning the bellwether 10-year Government of India security, one can sidestep the risk of active calls going wrong, as in gilt funds. Avoid tactical bets on credit risk funds, as the incremental return is often not commensurate with the risk taken.
Yields in debt funds are modest
Few debt fund categories can provide sharp capital appreciation when interest rates start cooling.
How to pick high-yield bonds: Retail investors today have easy access to all types of bonds via online bond platform providers. While investing directly in high-yield bonds and NCDs, investors must exercise utmost caution. Lathkar observes, “Unlike equities, the fixed income game is binary. Either you get back your principal or you don’t.” The bonds on offer differ vastly in credit quality, from AAA and sovereign bonds to securities rated AA and below (up to BBB-). Vishal Goenka, Co-founder, IndiaBonds. com, insists investors must get a clear grasp of the risk matrix. “In bonds, risk doesn’t simply go up in linear fashion as you go down the credit quality ladder.”
VISHAL GOENKA
CO-FOUNDER,INDIABONDS.COM
“Investors must go beyond the issuer’s credit rating and look at the company’s historical performance, interest coverage and nature of security cover.”
It gets disproportionately higher at the lowest rungs of the credit ladder, but is not always captured in the bond pricing or yields. So, an AA-rated issuer is riskier than an AAA-rated one, but an A-rated issuer is several times riskier than an AA-rated issuer. Further, pricing of bonds (as reflected in the yield) within the same rating bucket (such as AA-, AA, AA+) is often very similar. Yet, the credit profile of businesses in the same rating bucket can differ vastly.
Bardia says investors must avoid blindly chasing yields. “Within the same rating bucket, it is best to go for the safest, even if it offers a lower yield,” he says. Before opting for a high-yield NCD, make sure it compensates for the higher risk in the form of a higher spread—extra yield over NCDs of similar credit rating and tenure. Today, the average yield on offer for a three-year AA-rated bond is 8.32%. If a low-profile AA-rated NBFC is offering less than 9% for three years, it’s not a good deal.
Relying on credit ratings alone is not enough. Goenka asserts, “Credit rating is the first level of due diligence. Investors must go beyond issuer’s credit rating and look at the company’s historical performance, interest coverage and nature of security cover.” Bardia suggests investors verify the company’s fundamentals as well as share price performance in tandem. Often, this simple check can catch troubled issuers. If the company’s fundamentals seem strong but its stock price is falling, it may be a red flag. Investors must also consider the bond’s seniority in the payment hierarchy.
It reflects the order in which bondholders are repaid when the issuer turns insolvent. It will determine the chances of you getting back your principal in such an event. Senior secured bonds are placed at the top, enjoying first preference in repayment. Tier 2 subordinated bonds and perpetual (AT1) bonds lie at the bottom of the seniority ladder. Varun Fatehpuria, Founder and CEO, Daulat, a tech-enabled wealth management platform, remarks, “Make sure you understand the bond’s hierarchy within its issuer’s capital structure.
While subordinated bonds yield 100-150 bps higher returns, it is not worth the incremental risk.” However, seniority does not necessarily imply safety. If the issuer’s pedigree is weak, even a senior, secured bond can turn out to be a dud. Dewan Housing Finance NCDs are a case in the point. An unsecured NCD of a marquee entity can even be a safer bet than a secured NCD of an up-and-coming NBFC.
GIRISH LATHKAR
PARTNER AND CO-FOUNDER, UPWISERY PRIVATE WEALTH
“In fixed income, we are not psychologically used to losing money. That is why safety is most important.”While exploring lower down the credit ladder, avoid opting for longer tenure bonds. Fatehpuria says, “The lower rated segment of the bond market is not very liquid. It is best not to venture into bonds maturing beyond 24-36 months as these may not afford an exit at a good price if you need to take your money out.” Default risk can also get more pronounced over time if business conditions deteriorate. So, in terms of risk, an NCD offering 10% over a 24-month tenure may actually be better than one offering 11% over five years. Likewise, skip bonds offering cumulative or bullet payout, and stick with regular coupon paying bonds, avers Gupta.
“In case of bonds paying both principal and interest only at the end, your entire money can get stuck if the entity defaults. With regular coupon paying bonds, if the monthly payout stops, you can still exit,” he says. In case of NCDs with long tenure or cumulative payout, it may help if it is accompanied by a put option, as it will allow you an early exit if you perceive elevated risks. Besides, investors must enforce strict hygiene rules in picking individual bonds and NCDs.
Make sure you are diversified across at least four-five different issuers, with no single issuer accounting for more than 5% of your total portfolio. Even if buying AAA-rated PSU bonds, diversify across different entities. Go for issuers with lower leverage, or debt-equity ratio. Stick with listed NCDs. Unlisted NCDs are not only illiquid but also a blind spot in terms of financial disclosures.
Should you buy securitised debt instruments?
GripInvest and Wint Wealth are now offering securitised debt instruments (SDIs). To avoid the risk of default in individual loans, multiple types of loans are pooled together in a single bucket of interest earning securities. Pass-through certificates (PTCs) are issued by a special purpose vehicle (SPV) to investors against these securitised loans. These are typically backed by various tangible assets, such as loans, lease rentals, invoices and other receivables. The cash flow from the underlying pool of assets is used to service the securities issued by the SPV.
SDIs allow fractionalised investments in multiple bonds, even as the minimum face value of listed debt securities under private placement is Rs 1 lakh. Instead of putting in `5 lakh to buy five different bonds, SDIs offer this diversification by investing in a single instrument with a smaller outlay. Even as traditional bonds or NCDs return the principal amount only at the end of the tenure, SDIs pay back a portion of the principal, along with the monthly interest payouts, over their tenure, facilitating better cash flow. In the absence of any cash collateral and other credit enhancements, the basket may be assigned a credit rating that is aligned with the rating of the lowest rated bond in the pool.
Caution and diligence are advisable when investing in SDIs. Depending on the nature of underlying securities, the basket may carry potent credit, liquidity, and market risks. The pooled securities are carved into different tranches representing varying risk, yield or other characteristics.
Bardia cautions, “Investors will never be able to verify the underlying pool of receivables. SDIs don’t always offer diversification, as multiple receivables from the same company may be packaged in a single instrument.” If chosen well, SDIs are a potent vehicle for earning higher yield. Investors must, however, take the help of a financial adviser to gauge the profile of underlying pool of receivables.
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This story originally appeared on: India Times - Author:Faqs of Insurances
