August 30, 2020

The Risky Search For Yield

With bank interest rates at long-term lows, many investors are getting their first real taste of reinvestment risk.  Unfortunately, it can lead to far more hazardous consequences than what the textbooks suggest.  From what I have seen in the past, a lot of investors find it hard to accept low yields for what they are.  They end up taking more risk than they understand and are capable of weathering- something an investor should never do.

This time around as well, I have come across a number of people who, chasing a desperate desire for high yield, have made dubious investment choices. In this post, I’d like to present a few cautionary examples.  I’ve divided these investors into three broad categories.

Past Performance Chasers
The common factor across investors in this group is that they are first time debt fund investors who have been hooked by the general performance of debt funds over the last 1-2 years.  They have no grasp on how those astonishing returns came about.  Notwithstanding the statutory disclaimer, they believe that past performance is some kind of indicator of future returns.  As a result, they expect that debt funds will generally outperform bank fixed deposits.

Their fund choices are varied.  Hence, the manner and degree that they run the risk of being disappointed varies. Based on that, I could further divide them into a few smaller groups.

  • Investors who opted for high credit quality funds with very short durations, without realizing that the net yields of those funds are lower than the interest rates of comparable bank deposits.
  • Investors with little or no understanding of credit risk, who opted for high yield funds.  Remarkably, perhaps shockingly, some were unaware of the happenings surrounding IL&FS, DHFL and Franklin Templeton.
  • Investors with no understanding of interest rate risk, who opted for gilt funds, believing this to be the safest category of mutual funds for a first time investor.

Duration Migrants
These are investors who have had some experience with debt funds, typically in the ultra short and low duration categories.  They have clear credit quality preferences and within that, have looked for funds with the best yields.  After seeing yields drop at the short end of the curve, they decided to switch to longer duration funds.  While they are aware of interest rate risk, their understanding of that risk leaves a lot to be desired. 

As one example that illustrates their thinking, consider this exchange that I had with someone who recently invested in a certain Banking and PSU debt fund.

Me: Are you aware that this fund currently has a modified duration of around 5 years?

Investor: I matched the duration to my own time horizon.  I need this money only after 5 years.  That ensures that there will be no interest rate risk.  And since interest rates will inevitably go up, I will also gain from the increased yields.

Me: Let’s say that sometime next week, RBI hikes rates and the yields go up by 0.25%.  Let’s further say that the modified duration and the yields thereafter remain unchanged for the entire 5 years that you are invested.  Compared to the current net portfolio yield, will your overall return be lower or higher?

Investor: For almost the entire tenure, I’ll be getting a higher yield.  Obviously, my return will be higher than the current yield.

Me: I think you need to check your maths.  When the yields go up by 0.25%, your NAV will fall by approximately 1.25%.  It will take around 5 years for the enhanced yield to just make up for that fall.  Do remember, this is assuming that rate hike happens sometime next week.  If it were to happen one year from now, it will take 5 years (or whatever the modified duration is, at the time) from that point, for the enhanced yield to just make up for the fall.  In effect, just to get the current yield, you’d need to hold the investment for around 6 years.  If that rate hike were to happen 3 years from now,  you’d need to hold the investment for around 8 years.

Blinded By Bonds
The common thread across these investors is that they have been tempted by supposedly high yields to invest directly into bonds in the secondary market. While they fear credit risk enough to stick to bonds of reputed companies, they are unfamiliar with the basic nature of bonds.  I came across a particularly troubling example of this in investors who have bought a certain bond of SBI that is maturing in 2026, and which carries a coupon of 9.95% p.a.

It seems to be a very popular bond among individual investors.  Apparently, the primary attraction is the yield to maturity which, based on the last traded price, is around 8.60% p.a.  However, it appears that this bond carries a call option in March, next year.  More to the point, if my calculations are correct, the yield to call over the past month at least, has been consistently negligible or even negative.  In other words, if SBI chooses to call back this bond, there are investors who will get back less than what they invested- possibly hundreds, if not thousands of investors. 

From what I can make out, these investors are ignorant about the importance of yield to call and yield to worst.  What’s more, none of the bond platforms that I saw, highlighted either of these.

When I raised this with an investor, his response was a counter-question: “Will SBI really call back this bond?”  Personally, I can’t see a reason why SBI would want to continue paying a 9.95% coupon in the current low yield scenario.  For the sake of those investors, I can only hope that SBI’s humanitarian considerations outweigh its commercial considerations.

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