Income funds appear to be cresting the returns wave, with some deft manoeuvring in terms of maturities of securities held by them, even if it means taking on some interest rate risk. Debt fund managers typically take exposure to interest rate risk, credit risk, or both, to drive the performance of their income funds and generate the desired alpha. Higher exposure to interest rate risk comes from taking positions in longer maturity bonds. Given that bond prices move inversely with interest rates (bond prices fall when interest rates rise and vice versa), depending on which way the interest rates move, the losses/gains on longer maturity papers are higher compared with shorter maturity papers. Alternatively, a fund can take an exposure to higher credit risk by investing in bonds with lower credit rating.
A study by CRISIL indicates income funds see interest rate risk as the more benign of the two.
The study analysed the returns of 39 income funds between April 2013 and December 2016. It compared the performance of these funds with that of the CRISIL Composite Bond Fund Index, which tracks the performance of debt funds that invests predominantly in government securities, AAA and AA rated bonds and is, therefore, an apt benchmark. Interestingly, most of the funds are unable to beat the benchmark on a consistent basis. There are only 8 funds out of the 39 funds in the study that were able to outperform the benchmark in 3 years since April 2013.
The top and bottom 20 per cent of the funds, based on performance for each financial year, were identified. The top 20 per cent beat the benchmark by a yard in most of the years (see chart).
The study then set out to identify the reasons for outperformance and underperformance, by comparing the funds on parameters such as modified duration (MD) and asset allocation vis-à-vis the benchmark index.
MD measures the potential changes in the price of a bond for every 100 basis points (bps) change in yield. Given that bond yields indicate the market’s interest rate expectations, MD acts as a measure of interest rate risk. Accordingly, when the interest rate cycle is trending down, a portfolio with higher MD will result in higher returns (capital gain), compared with a portfolio with lower MD. The opposite will hold when interest rates are rising.
The study showed that the MD of CRISIL Composite Bond Fund Index since 2013 has moved within a narrow range of 4.26-5.15. During the financial year 2013-14, when the yields on the benchmark 10-year G-Sec increased 144 bps, MD was lower than that of the benchmark for the outperformers and higher for the underperformers. Similarly, in fiscal 2015, which saw interest rates easing (the 10-year G-Sec yield came off as much as 81 bps), MD was significantly higher for the outperformers and lower for the underperformers. This was the case even in fiscal 2017 (till December).
Only in FY16, which was a volatile year, with yields swinging both ways and ending flat, no income fund was able to beat the benchmark.
A comparison of asset allocation, which is a measure of exposure to credit risk, also showed a distinct trend. The funds with higher MD had higher allocation to G-Secs and lower allocation to lower-rated papers, indicating lower credit risk, while funds with lower MD had lower allocation to G-Secs higher exposure to lower-rated papers.
This could be forced, in a way. Given the illiquid nature of the corporate bond market at the longer end of the maturity spectrum, the only avenue for a fund to increase its MD is to invest more in G-Secs.
All the same, active duration management emerges as the key to the performance of income funds, though in the case of a few funds, it was observed that the duration varied in a narrow range. This could be on account of their policy or mandate, which doesn’t allow these to increase or decrease the duration beyond a certain point in view of the risks involved.
Therefore, as is the case of other asset classes and mutual fund categories, investors should note all the risks involved before investing in these funds.