The debt mutual fund space has seen a bit of upheaval. Lessons have been learnt and now the fixed income markets are currently undergoing a phase of transformation and consolidation. As life is all about progress, when it comes to investments it is all about finding the next attractive investment opportunity. For debt fund investors, 2020 is all about 'spending time in the middle' just like a batsman in cricket.
Given the current interest rates and anticipated movements in bond prices, medium term bond funds have emerged as the best bet for the year 2020. For the uninitiated, extreme short duration funds stare at lower real returns territory while yields at the longer end of the curve are poised for volatility. In this backdrop, medium term bond are very attractively placed. Read on to understand how.
What is Medium Term Bond Fund?
As per regulator SEBI's scheme categorization, medium duration funds (or medium term bond funds) are a category of schemes that endeavor to have a portfolio with a Macaulay duration between 3 to 4 years under normal circumstances. Macaulay duration is the weighted average term to maturity of the cash flows from the bond. The weight of each cash flow is determined by dividing the present value of the cash flow by the price.
Medium duration fund category today has many schemes with a collective asset under management of over Rs 30,000 crore which is spread over 2.66 lakh folios. In January 2020, the category mobilized funds of over Rs 650 crore. In terms of folio growth, the category has seen 10% rise compared to April 2019 figures.
In the last 1-year period, the top performing fund in this category has generated return in the range of 9-13%. On a 3-year basis, the returns range between 4-8.7% CAGR.
The Case for Medium Duration
Medium term bond funds keep the duration of their portfolio between 3-4 years. Coincidentally, this is the right duration to be in, especially in the backdrop of the current fixed income market outlook. Medium term bond funds offer the potent combination of short term assets and long term assets.
The extreme short end (less than 3 months) of the curve due to ample liquidity has moved into lower real returns territory. Hence, moving up the yield curve is recommended. On the longer end of the yield curve, increased borrowings from central government and state governments as well as central PSUs has heightened fiscal concerns for India, which may keep yields at the longer end volatile.
Given the yield outlook, it is recommended that investors target the 2-5 year space for gains. Well-managed medium term duration bond funds with a proven track record can help investors position for the anticipated gains.
From a contrarian perspective, medium term bond funds are an interesting opportunity since industry flows are slowing down while the narrative associated with category is negative. This has created a mispricing opportunity that investors can exploit ahead of the crowd.
Picking the Right Fund
As said before medium term bond funds form a compelling fixed income play for 2020. However, choosing the right fund is the next key task. This is of utmost importance as some of the funds in this category have given negative returns in the last one-year period. Hence, being invested in the right fund has to be with the aim when selecting the first among equals.
While choosing a good medium term bond fund, investors must focus on the following four parameters: 1) Investment philosophy, 2) Investment Process, 3) Strong credit selection framework and 4) Ability to deliver better risk adjusted returns. If a fund house managed to clear all these four parameters, then the risk of going wrong with such an investment is greatly reduced.
The one name which comes across as a consistent performer in this category is the ICICI Prudential Medium Term Bond Fund. It is also one of the best performing funds in this category.
One of the key attributes of the fund has been its consistency in performance despite the debt market turbulence seen over the past 1.5 years. This has been possible due to the fund’s focus on generating risk adjusted returns, rather than focusing only on YTMs (Yield to Maturities). Over the past few years, many investors were attracted to schemes which had higher YTMs in the hope that higher YTMs would lead higher returns. Over time this proved to be an erroneous notion.
The other aspect which aided in the fund’s performance is the diversity maintained both on the asset (portfolio construction) as well as liabilities (investor concentration and trend) side of the portfolio. Such an approach helped ICICI Prudential to stay away from major credit stress/event on the portfolio. Also, the ideal medium term bond fund's laddered approach i.e. investment across maturity buckets, helps deliver pleasant investor experience.
As an investor it is important to remember that a steady fund performance is possible on account of optimal management of liquidity, credit and duration all the while ensuring that the portfolio is not concentrated either on issuer or sector level. It is all of these factors which result in better risk-adjusted returns.
