Until debt mutual funds entered the scene, fixed income investing was a simple affair for Indian investors. You parked money in a bank fixed deposit, a small savings scheme or a deposit with a Sundaram Finance and pocketed the interest, sure of your principal being returned at maturity.
But debt mutual funds, with their open-end structure, have made life more complicated. With open end funds, investors are not just exposed to changing interest rates, but also to swings in their NAV caused by these rate moves. As a bond investor you must know that when interest rates in the market rise, prices of older bonds fall, leading to capital losses for those who sell before the bond’s maturity.
Mutual fund houses and debt managers, instead of explaining their strategies to contain these risks simply to investors, like to showcase debt investing as some kind of rocket science. They garnish their product notes, market views and interviews with jargon.
Right now, debt manager views are liberally sprinkled with terms that remind you of your morning workout. Here’s an explainer to demystify the barbells, ladders and roll-downs that are in vogue now.
Laddering
What’s it? A bond ladder is simply owning a portfolio of bonds that mature at different times in the future. A ladder has equally spaced rungs. So, if you have Rs 5 lakh to invest today and 5 years over which you’d like to earn returns, you decide to invest Rs 1 lakh equally in bonds maturing in March 2023, March 2024, March 2025, March 2026 and March 2027. As each of these bonds pays interest and matures you get a steady stream of regular cash flows.
Why do it? A laddering strategy helps you reduce reinvestment risk, which is the risk that you may have to invest a large lumpsum in bonds when interest rates are poor. Suppose you invested your entire Rs 5 lakh today and market interest rates fell from 6.8% percent today (based on 10-year government security yields) to 5% five years later, you’d be forced to ‘reinvest’ all your money at low rates. Laddering prevents this by phasing out your maturity dates.
Laddering is also useful to set up periodic cash flows from a bond portfolio both in the form of lumpsums and interest, while reducing rate risk. You can choose different instruments maturing in the future for your bond ladder.
If you’re a retiree who has just received Rs 50 lakh from your employer, who isn’t happy about locking in all your money at current rates, you may like to follow a laddering strategy. You can park say, Rs 10 lakh in the government’s 364-day T-bills, Rs 10 lakh in 2 year FDs from two small finance banks, Rs 10 lakh in the 3 year post office time deposit, Rs 10 lakh in the 5-year Senior Citizens Savings Scheme and Rs 10 lakh in GOI’s floating rate savings bonds that mature in 7 years. This way, you’d have Rs 10 lakh coming in every once in one or two years that you can reinvest at different levels of interest rates.
The flip side: A bond ladder takes quite a bit of micromanagement and decision-making, as you need to juggle multiple maturity dates and interest payouts and reinvest all the cash flows in optimal instruments. If you’re close to the top of a rate cycle and rates only head downhill from your date of investment, you’ll be forced to reinvest your maturity proceeds at lower rates, compared to the simpler strategy of locking the entire lumpsum into good rates at the beginning.
The Barbell
What’s it? A barbell is the thingie you use at the gym to lift weights. In bonds, a barbell strategy is using a combination of very safe and very risky instruments to build a portfolio. A barbell has equal weights at both ends. So, in this strategy, you split your money equally between very short-term bonds and very long-term ones and invest in both.
Suppose a rich uncle left you Rs 10 lakh today and you are unsure which debt instruments to bet on. A barbell strategy would mean investing Rs 5 lakh in liquid funds (which would own less-than 91 day securities) and Rs 5 lakh in 10-year government securities. The liquid funds would earn you about a 3.3% return today which could climb steadily as rates rise. The 10-year g-sec would fetch you about 6.8% yield if you hold to maturity.
Why do it? When interest rates are rising, as they are today, you may be torn between maximising your returns (yields) by buying long-term bonds and minimising the interest rate risk, by buying very short-term bonds. When you’re thus conflicted, you use a barbell strategy that lets you have the best of both the worlds. You ignore medium term bonds and stick only to very short term or very long-term bonds that either minimise risk to your capital or max out your yield.
The flip side: The half of your portfolio that’s in long-term bonds can underperform if you are at a mid-point in the rate cycle and interest rates keep rising further. If you have a large lumpsum to invest, a barbell won’t offer much diversification across maturities.
Roll Down or Bullet strategy
What’s it? In a roll-down strategy, you own a portfolio of bonds that all mature at the same date in future so that you get a somewhat predictable return based on the portfolio’s average maturity. The strategy’s called a roll-down strategy because you reduce (or roll down) the tenure for which you hold bonds as the maturity date approaches.
So, if you have Rs 5 lakh to invest today and want to follow a roll-down strategy with a 2027 maturity, you may park it in a combination of 5-year g-secs earning 6.1% and National Savings Certificates earning 6.8%, expecting a return of about 6.5%. Roll-down strategies are quite a hit with Indian debt fund managers today with many target maturity, PSU & Banking funds and corporate bond funds swearing by it.
Why do it? A roll-down strategy makes returns from a bond portfolio somewhat predictable in a volatile interest rate scenario. So, if you have a 5-year target maturity fund following a roll-down strategy that has a portfolio yield of 6.5% and an expense ratio of 0.30% today, you can be reasonably sure that your final returns will be close to 6.2% (yield minus expenses).
Roll-down strategies are best used when you have a specific financial goal coming up on a certain date and you’re targeting a specific return to reach it. For instance, if your plan is to fund your 8-year-old daughter’s degree in ten years’ time, you may like to start building a portfolio of State Development Loans maturing in 2032, that currently offer yields of over 7%. (You will need to carefully invest the periodic interest receipts though). Whenever you have surplus money to invest in the future, you can keep adding SDLs maturing in 2032 to this portfolio so that you have a hefty sum saved up by 2027.
The flip side: While a roll-down strategy is easy to implement in a close-end format where the fund manager only has to invest a lumpsum once, it is trickier to implement in an open-end format, where there are constant outflows and inflows in a fund. Suppose a debt fund following a roll-down strategy and targeting maturity in 2027 faces big outflows in 2024, it may be forced to redeem its 5-year bonds prematurely, even if it means taking a loss. This could reduce its returns.
Inflows can create issues for a roll-down fund too, as the fresh inflows need to be invested in bonds with a residual maturity that matches the fund’s existing one, without materially impacting its yield. Finding bonds with odd tenures such as 2 years or 4 years may not be easy in a shallow bond market like India’s.
Sweet spots
Apart from climbing ladders, lifting barbells and rolling down the stairs, debt fund managers are also constantly looking to play ‘sweet spots on the yield curve.’ This simply means that the manager is looking for the tenure that offers the best mix of risk and reward at any given point in time. As you know, in the bond market, bonds offer higher yields (rates) as you increase the tenure. This is because longer the tenure, the more risk the bond buyer takes on uncertain rates and default in payment.
A yield curve is essentially a graph that plots the yields offered by a single issuer for bonds of different maturities. Usually, government bonds are used to construct the market’s yield curve, which looks like this.
In the above image you can see that the yield ‘curve’ is steep between g-secs of 1 and 8-year maturity but flattens out after that. Essentially, as a g-sec buyer, when you lengthen your tenure from 1 year to 8 years you get much higher yields for taking on extra risk – your yield goes up from about 3.8% for the 1 year bond to 6.8% on the 8 year bond.
But when you stretch your tenure from 8 to 16 years you get barely any extra yield. Bond managers may therefore see more sense in sticking to 8-year bonds than bonds with longer tenures. This is currently the ‘sweet spot’ on the yield curve. The sweet spot may keep shifting as market interest rates move.
Well, now that you’re conversant with all the jargon, go ahead and treat yourself to a bond workout! But don’t try to work out what a debt fund manager is doing with his debt fund, because that’s very hard to figure from portfolios, yield trends or maturity trends – unless the fund manager declares it!
