Making money through debt

You can leverage the changes in interest rates and credit quality

"Where do I park my money for the best returns?" is a standard investor query. The standard answer might well be, "put it in equities and forget it for 5-7 years." But, while there is no denying the power of equities to deliver phenomenal returns over the long term, some tactical moves can help you enhance the returns on your portfolio in the short run.

Investment in debt mutual funds, for one, allows you to take a bet on the changes in interest rates and credit quality that can help you get some extra returns.

What is a debt mutual fund?
A debt mutual fund invests in fixed income securities. In India, the government is the largest issuer of these securities (due to its need to finance its expenses and investments), followed by banks (which issue fixed deposits) and corporates (which issue commercial paper). These funds also invest in securitised papers. The securities issued by a borrower can mature anywhere between 15 days to 30 years.

A debt mutual fund will invest in any of the above types of securities. Depending on the type and tenure of security that it chooses, a fund manager can seek to deliver different risk-return options for the investor.

Returns in a debt fund
A debt fund typically has two components of return:
Yield = Interest rate + capital gain/loss
Capital gain/loss can arise from:
a) changes in interest rate and/or
b) changes in credit quality

Interest rate: Interest is the compensation paid by the borrower to the lender for foregoing present consumption. Because the lender is not using the money he has for consumption today, he expects the lender to provide him with some compensation. With the general tightening of the interest rates in the country, the yield due to interest rate has risen over the last 6 - 12 months.

Capital gain/loss: If there is any change in the interest rates or in the credit quality of the borrower, the security issued by it is re-priced.

Interest rate changes: Interest rates and prices of the bonds move in opposite directions. Let us understand how/ why this happens. A bond is a security in which the payments are defined. As the interest rate changes, the present value of the cash flow to you changes. If interest rate rises, it means the present value of the future payments that you will receive is lower today. This is because the value of consumption today is higher than what it was before the rates increased. Similarly, when interest rates fall, the bond that keeps paying higher cash flows will become more valuable.

The relationship between the change in the price of a bond and interest rates is captured by a measure called "duration." If the duration of the bond is say, 7 years, and if the interest rates change by 1%, then the price of the bond will change by 7%.

Change in price of a bond = change in interest rates X duration
Duration is linked to the tenure of the bond: the longer the tenure of the bond, typically, longer is the duration. If your bet is that the interest rates will come down, then you would want to invest in a long-duration bond fund. As the rates fall, you will get a yield-kicker.

Credit spread changes: When the borrower is risk-free (for example, the government of India), the interest rate charged does not include any risk premium for credit quality. However, when a corporate issues a bond, then it is charged a higher rate of interest, to reflect the fact and compensate for any default. As we noted earlier, most of the bond issuance in India is by the government, and there is limited scope for mutual funds to play on credit spread changes.

Corporate instruments are rated by credit-rating agencies, which mention how creditworthy the investment instrument is. For example, AAA rating indicates the highest safety rating and it does all the way down to D, which indicates default by the corporate. Corporates who do not have a high rating of safety need to compensate the investors through a higher yield. If the rating of the corporate changes for the better (or worse), the rate of return that market will demand from it will fall (or rise). A fall in the rate demanded by the market will lead to a rise in the price of the bonds issued by the corporate.

Many funds are mandated to invest in lower rated bonds to earn higher returns. Of course, there is a risk that the corporate can default or delay the payments, but that is compensated through higher returns. Similarly, funds try to move to a corporate whose safety rating is expected to increase, and hence the value of its bonds will increase.

What should you consider?
Investment in funds that bet on lower rated corporate paper can be very profitable when the economy is turning around after a recession, as many corporates move to a higher credit rating. In the current scenario, when the economy is in a boom, this is not a very profitable strategy.

In the current scenario, with the interest rates peaking, you can consider investing in long tenure debt funds. As the interest rates fall, you can expect to make capital gains on your portfolio.

The author is director, PARK Financial Advisors, Mumbai. He is an MBA from IIM Ahmedabad.

info@parkfa.com.