Will debt funds start losing their sheen from this financial year? probably not

Rise of Debt AIFs

In the last year, there has been a surge in interest in the high-yielding debt AIF space, as most debt MFs earned anywhere between 3-5% gross returns due to the sharp rise in interest rates. Over the same period, consumer price inflation (CPI) rose by more than 6%, leaving investors with negative real returns. Even for investors who were willing to allocate to credit risk MFs, the returns were much lower than AIFs. MFs sharply cut their allocation to the mid-corporate segment from 2018-19 onwards following the IL&FS default and the Franklin Templeton debt fund crisis. As a result, mid-market enterprises have faced a lack of access to credit, which has presented an opportunity for structured and private debt AIFs.

Debt AIFs provide an opportunity to invest in multiple strategies such as structured credit, venture debt, mezzanine debt etc., which can give investors an aggregate return of 15-18%. This has driven interest towards Debt AIFs apart from their professionally managed, diversified offering. etc.

Investing in debt AIFs however is not for the average investor and comes with its own risks and limitations, including the regulatory minimum investment of Rs 1 crore required primarily for high net worth individuals and family offices. Therefore, while debt AIFs may find a place in some portfolios, we recommend following the basic principles of asset allocation when building a fixed income portfolio.

Actively managed debt MFs are important

While any tax arbitrage (in debt instruments) has become meaningless as a result of the taxation changes, the grandfathering of long-term capital gains for all investments made up to March 31 is an important factor in helping these gains continue for the next several years. There is a solution. Mutual funds also offer portfolio liquidity and minimal to zero exit load, which is attractive compared to other debt products. Also, given that most rate hikes are behind us, we believe this is a great opportunity to start allocating to actively managed debt MFs. We see a dual benefit in doing this:

First, as rates plateau, there is a limited negative impact on the fund net asset value, or NAV, (which may arise due to any future rate hikes) thus providing investors with a locked-in entry. Helps in bringing the yield near peak. This helps in getting attractive carries as long as rates remain high.

Second, when rates in the system begin to decline (via a policy rate cut), managers can potentially increase the modified duration of their funds, thus helping to participate in marked-to-market gains for the investments made. .

A combination of these two factors can offer double digit or higher holding period returns that are relatively cost effective and provide liquidity at all points in time.

On an after-tax basis, returns will continue to be attractive (as we believe mark to market, or MTM, movement will partially offset the negative tax impact). There are investment opportunities across all fund categories as per the risk appetite of the investor:

For conservative investors, a high credit quality accumulation-oriented fund portfolio may be suitable where one can take interest rate risk but will be protected against credit risk.

Balanced investors may consider a combination of duration-oriented strategies along with some allocation to accumulation.

Aggressive investors can consider a combination of 70% fixed income investments in mutual funds, with the remaining 30% towards high yielding debt AIFs, which has the potential to create an optimal fixed income portfolio for the next 4-6 years.

While it is still early days, the SEBI classification allows AMCs to come up with funds in the “balanced hybrid” category (defined by an allocation to different equities in the band of 40-60%). They can benefit from the current tax regime. (LTCG at 20% with indexation for holding period exceeding 3 years). However, this category may prove volatile as compared to conservative hybrid funds or pure play debt funds. An alternative can be Balanced Advantage Fund where the risk is limited. Equity exposure with 35% allocation to Fixed Income.

Going into the next financial year, a combination of these strategies will help in optimizing the allocation in the fixed income portfolio. In short, it is not an ‘either or’ approach but an ‘and’ approach that can help investors more effectively navigate the structural changes in the debt space in the coming months.

Nitin Rao is the CEO of Incred Wealth