ETFs, Debt and Liquid Funds PDF

UNIT-5 : ETFs, Debt and Liquid Funds 5.1 Introduction to Exchange Traded Funds Exchange Traded Funds (ETFs) are mutual fund units which investors buy/ sell from the stock exchange, as against a normal mutual fund unit, where the investor buys / sells through a distributor or directly from the AM...

UNIT-5 : ETFs, Debt and Liquid Funds 5.1 Introduction to Exchange Traded Funds Exchange Traded Funds (ETFs) are mutual fund units which investors buy/ sell from the stock exchange, as against a normal mutual fund unit, where the investor buys / sells through a distributor or directly from the AMC. ETF as a concept is relatively new in India. It was only in early nineties that the concept gained in popularity in the USA. ETFs have relatively lesser costs as compared to a mutual fund scheme. This is largely due to the structure of ETFs. While in case of a mutual fund scheme, the AMC deals directly with the investors or distributors, the ETF structure is such that the AMC does not have to deal directly with investors or distributors. It instead issues units to a few designated large participants, who are also called as Authorised Participants (APs), who in turn act as market makers for the ETFs. The Authorised Participants provide two way quotes for the ETFs on the stock exchange, which enables investors to buy and sell the ETFs at any given point of time when the stock markets are open for trading. ETFs therefore trade like stocks. Buying and selling ETFs is similar to buying and selling shares on the stock exchange. Prices are available on real time and the ETFs can be purchased through a stock exchange broker just like one would buy / sell shares. Due to these lower expenses, the Tracking Error for an ETF is usually low. Tracking Error is the acid test for an index fund/ ETF. By design an index fund/ index ETF should only replicate the index return. The difference between the returns generated by the scheme/ ETF and those generated by the index is the tracking error. Assets in ETFs Practically any asset class can be used to create ETFs. Globally there are ETFs on Silver, Gold, Indices (SPDRs, Cubes, etc), etc. In India, we have ETFs on Gold, Indices such as Nifty 50, Bank Nifty etc.). Index ETF An index ETF is one where the underlying is an index, say Nifty 50. The APs deliver the shares comprising the Nifty, in the same proportion as they are in the Nifty, to the AMC and create ETF units in bulk (These are known as Creation Units). Once the APs get these units, they provide liquidity to these units by offering to buy and sell through the stock exchange. They give two way quotes, buy and sell quote for investors to buy and sell the ETFs. ETFs therefore have to be listed on stock exchanges. There are many ETFs presently listed on the NSE. For further details please check NSE website http://www.nseindia.com Below path Home>>Products>>Equities>>Exchange Traded Funds 5.2 Salient Features An Exchange Traded Fund (ETF) is essentially a scheme where the investor has to buy/ sell units from the market through a broker (just as he/ he would by a share). An investor must have a demat account for buying ETFs (For understanding what is demat please refer to NCFM module ‗Financial Markets : A Beginners‘ Module). An important feature of ETFs is the huge reduction in costs. While a typical Index fund would have expenses in the range of 1.5% of Net Assets, an ETF might have expenses around 0.75%. In fact, in international markets these expenses are even lower. In India too this may 88  be the trend once more Index Funds and ETFs come to the market and their popularity increases. Expenses, especially in the long term, determine to a large extent, how much money the investor makes. This is because lesser expenses mean more of the investor‘s money is getting invested today and over a longer period of time, the power of compounding will turn this saving into a significant contributor to the investors‘ returns. Scheme A B Investment (Rs.) 10000 10000 Expense Ratio 1.50% 0.75% Term (Years) 25 25 Compounded Average Growth Rate (CAGR) 12% 12% Amount (Rs.) 116508.16 140835.93 Difference (Rs.) 24327.77 If an investor invests Rs.10,000 in 2 schemes each, for 25 years, with both the schemes delivering returns at a CAGR of 12% and the only difference being in the expenses of the schemes, then at the end of the term, while scheme A would have turned the investment into Rs.1.16 Lakhs, scheme B would have grown to Rs.1.40 Lakhs – a difference of Rs.24,327.77. Post expenses, scheme A‘s CAGR comes out to be 10.32%, while scheme B‘s CAGR stands at 11.16%. Concept Clarifier – Buying/ Selling ETFs An investor can approach a trading member of NSE and enter into an agreement with the trading member. Buying and selling ETFs requires the investor to have demat and trading accounts. The procedure is exactly similar to buying and selling shares. The investor needs to have sufficient money in the trading account. Once this is done, the investor needs to tell the broker precisely how many units he wants to buy/ sell and at what price. Investors should take care that they place the order completely. They should not tell the broker to buy/ sell according to the broker‘s judgement. Investors should also not keep signed delivery instruction slips with the broker as there may be a possibility of their misuse. Placing signed delivery instruction slips with the broker is similar to giving blank signed cheques to someone. 89 5.3 What are REITs? REITs or Real Estate Investment Trusts are similar to mutual funds. They invest in real estate assets and give returns to the investor based on the return from the real estate. Like a mutual fund, REITs collect money from many investors and invest the same in real estate properties like offices, residential apartments, shopping malls, hotels, warehouses). These REITs are listed on stock exchanges. The investors can directly buy and sell units from the stock exchanges. REITs are actually trusts and hence their assets are in the hands of an independent trustee, held on behalf of the investor. The trustee is bound to ensure compliance with applicable laws and protect the rights of the unit holders. Income takes the form of rentals and capital gains from property which is distributed to investors as dividends. Money is raised from unit holders through IPO (Initial Public Offer). 5.4 Why Gold ETF? Gold ETFs (G-ETFs) are a special type of ETF which invests in Gold and Gold related securities. This product gives the investor an option to diversify his investments into a different asset class, other than equity and debt. Traditionally, Indians are known to be big buyers of Gold; an age old tradition. Gold as an asset class is considered to be safe This is because gold prices are difficult to manipulate and therefore enjoy better pricing transparency. When other financial markets are weak, gold gives good returns. It also enjoys benefit of liquidity in case of any emergency. We buy Gold, among other things for children‘s marriages, for gifting during ceremonies etc. Holding physical Gold can have its‘ disadvantages: 1. Fear of theft 2. Payment Wealth Tax 3. No surety of quality 4. Changes in fashion and trends 5. Locker costs 6. Lesser realisation on remoulding of ornaments G-ETFs can be said to be a new age product, designed to suit our traditional requirements. G - ETFs score over all these disadvantages, while at the same time retaining the inherent advantages of Gold investing. In case of Gold ETFs, investors buy Units, which are backed by Gold. Thus, every time an investor buys 1 unit of G-ETFs, it is similar to an equivalent quantity of Gold being earmarked for him some w here. Thus his units are ‗as good as Gold‘. Say for example 1 G-ETF = 1 gm of 99.5% pure Gold, then buying 1 G-ETF unit every month for 20 years would have given the investor a holding of 240gm of Gold, by the time his child‘s marriage approaches (240 gm = 1 gm/ month * 12 months * 20 Years). After 20 years the investor can convert the G-ETFs into 240 gm of physical gold by approaching the mutual fund or sell the G-ETFs in the market at the current price and buy 240 gms. of gold. Secondly, all these years, the investor need not worry about theft, locker charges, quality of Gold or changes in fashion as he would be holding Gold in paper form. As and when the investor needs the Gold, he may sell the Units in the market and realise an amount equivalent to his holdings at the then prevailing rate of Gold ETF. This money can be used to buy physical gold and make 90 ornaments as per the prevailing trends. The investor may also simply transfer the units to his child‘s demat account as well. Lastly, the investor will not have to pay any wealth tax on his holdings. There may be other taxes, expenses to be borne from time to time, which the investor needs to bear in mind while buying / selling G-ETFs. 5.5 Working The G-ETF is designed as an open ended scheme. Investors can buy/ sell units any time at then prevailing market price. This is an important point of differentiation of ETFs from similar open ended funds. In case of open ended funds, investors get units (or the units are redeemed) at a price based upon that day‘s NAV. In case of ETFs, investors can buy (or sell) units at a price which is prevailing at that point of time during market hours. Thus for all investors of open ended schemes, on any given day their buying (or redemption) price will be same, whereas for ETF investors, the prices will vary for each, depending upon when they bought (or sold) uni ts on that day. The way Gold ETFs work is as under: 5.5.1 During New Fund Offer (NFO)  AMC decides of launching G-ETF  The SID, SAI and KIM are prepared as per SEBI guidelines  Investors invest in the fund and the AMC gives units to investors in return AMC buys Gold of specified quality at the prevailing rates 5.5.2 On an ongoing basis  Authorised Participants (typically large institutional investors) give money/ Gold to AMC  AMC gives equivalent number of units bundled together to these authorized participants (AP)  APs split these bundled units into individual units and offer for sale in the secondary market  Investors can buy G-ETF units from the secondary markets either from the quantity being sold by the APs or by other retail investors  Retail investors can also sell their units in the market The Gold which the AP deposits for buying the bundled ETF units is known as ‗Portfolio Deposit‘. This Portfolio Deposit has to be deposited with the Custodian. A custodian is someone who handles the physical Gold for the AMC. The AMC signs an agreement with the Custodian, w here all the terms and conditions are agreed upon. Once the AP deposits Gold with the custodian, it is the responsibility of the custodian to ensure safety of the Gold, otherwise he has to bear the liability, to the extent of the market value of the Gold. The custodian has to keep record of all the Gold that has been deposited/ withdrawn under the G-ETF. An account is maintained for this purpose, which is known as ‗Allocated Account‘. The custodian, on a daily basis, enters the inflows and outflows of Gold bars from this account. All details such as the serial number, refiner, fineness etc. are maintained in this account. The transfer of Gold from or into the Allocated Account happens at the end of each business day. A report is submitted by the custodian, no later than the following business day, to the AMC. The money which the AP deposits for buying the bundled ETF units is known as ‗Cash Component‘. This Cash Component is paid to the AMC. The Cash Component is not mandatory and is paid to adjust for the difference between the applicable NAV and the market value of the 91 Portfolio Deposit. This difference may be due to accrued dividend, management fees, etc. The bundled units (which the AP receives on payment of Portfolio Deposit to the custodian and Cash Component to the AMC) are known as Creation Units. Each Creation Unit comprises of a pre - defined number of ETFs Units (say 25,000 or 100 or any other number). Thus, now it can be said that Authorised Participants pay Portfolio Deposit and/ or Cash Component and get Creation Units in return. Each Creation Unit consists of a pre-defined number of G-ETF Units. APs strip these Creation Units (which are nothing but bundled G-ETF units) and sell individual G-ETF units in the market. Thus retail investors can buy/ sell 1 unit or it‘s multiples in the secondary market. 5.6 Sovereign Gold Bonds The Government of India in October 2015 launched the Sovereign Gold Bonds Scheme SGB scheme offer investors returns that are linked to gold price and provides benefits similar to investment in physical gold SGBs are issued by the Reserve Bank of India on behalf of the Government of India and distributed through Agents like banks, designated post offices and Stock Holding Corp. Exchanges to be appointed as Agents from Tranche IV onwards SGBs are issued on payment of rupees and denominated in grams of gold and can be held in demat and paper form SGBs can be used as collateral for loans and can be traded on stock exchanges Can be bought initially through Stock brokers / Mutual Fund Distributors Commission would be 99bps. 5.6.1 Product Details of Sovereign Gold Bonds SI. No. Item Details 1 Product name Sovereign Gold Bond 2016-17 – Series *** 2 Issuance To be issued by Reserve Bank India on behalf of the Government of India. 3 Eligibility The Bonds will be restricted for sale to resident Indian entities including individuals, HUFs, Trusts, Universities and Charitable Institutions. 4 Denomination The Bonds will be denominated in multiples of gram(s) of gold with a basic unit of 1 gram. 92 SI. No. Item Details 5 Tenor The tenor of the Bond will be for a period of 8 years with exit option from 5th year to be exercised on the interest payment dates. 6 Minimum size Minimum permissible investment will be 1 grams of gold. 7 Maximum limit The maximum amount subscribed by an entity will not be more than 500 grams per person per fiscal year (April-March). A self-declaration to this effect will be obtained. 8 Joint holder In case of joint holding, the investment limit of 500 grams will be applied to the first applicant only. 9 Issue price Price of Bond will be fixed in Indian Rupees on the basis of simple average of closing price of gold of 999 purity published by the India Bullion and Jewellers Association Limited for the week (Monday to Friday) preceding the subscription period. 10 Payment option Payment for the Bonds will be through cash payment (upto a maximum of Rs. 20,000) or demand draft or cheque or electronic banking. 11 Issuance form Government of India Stock under GS Act, 2006. The investors will be issued a Holding Certificate. The Bonds are eligible for conversion into demat form. 12 Redemption price The redemption price will be in Indian Rupees based on previous week‘s (Monday-Friday) simple average of closing price of gold of 999 purity published by IBJA. 13 Sales channel Bonds will be sold through banks, Stock Holding Corporation of India Limited (SHCIL), designated post offices as may be notified and recognised stock exchanges viz., National Stock Exchange of India Limited and Bombay Stock Exchange, either directly or through agents. 14 Interest rate The investors will be compensated at a fixed rate of 2.75 per cent per annum payable semi-annually on the initial 93 SI. No. Item Details value of investment. 15 Collateral Bonds can be used as collateral for loans. The loan to- value (LTV) ratio is to be set equal to ordinary gold loan mandated by the Reserve Bank from time to time. 16 KYC Documentation Know-your-customer (KYC) norms will be the same as that for purchase of physical gold. KYC documents such as Voter ID, Aadhaar card/PAN or TAN /Passport will be required. 17 Tax treatment The interest on Gold Bonds shall be taxable as per the provision of Income Tax Act, 1961 (43 of 1961). The capital gains tax arising on redemption of SGB to an individual has been exempted. The indexation benefits will be provided to long term capital gains arising to any person on transfer of bond 18 Tradability Bonds will be tradable on stock exchanges/NDS-OM from a date to be notified by RBI. 19 SLR eligibility The Bonds will be eligible for Statutory Liquidity Ratio purposes. 20 Commission Commission for distribution of the bond shall be paid at the rate of 1% of the total subscription received by the receiving offices and receiving offices shall share at least 50% of the commission so received with the agents or sub agents for the business procured through them. 94 5.7 Market making by Aps APs are like market makers and continuously offer two way quotes (buy and sell). They earn on the difference between the two way quotes they offer. This difference is known as bid -ask spread. They provide liquidity to the ETFs by continuously offering to buy and sell ETF units. If the last traded price of a G-ETF is Rs 1000, then an AP will give a two way quote by offering to buy an ETF unit at Rs 999 and offering to sell an ETF unit Rs. 1001. Thus whenever the AP buys, he will buy @ 999 and when he sells, he will sell at 1001, thereby earning Rs. 2 as the difference. It should also be understood that the impact of this transaction is that the AP does not increase/ decrease his holding in the ETF. This is known as earning through Dealer Spreads. APs also play an important role of aligning the price of the unit with the NAV. This is done by exploiting the arbitrage opportunities. It should be understood that it is not only APs who can sell ETF units in the market. Retail investors get liquidity by selling their units as well. So it is not always that the buyer of units is necessarily buying fro m APs – the seller at the other end may be a retail investor who wishes to exit. As explained earlier, the custodian maintains record of all the Gold that comes into and goes out of the scheme‘s Portfolio Deposit. The custodian makes respective entries in the Allocated Account thus transferring Gold into and out of the scheme at the end of each business day. The custodian has no right on the Gold in the Allocated Account. The custodian may appoint a sub-custodian to perform some of the duties. The custodian charges fee for the services rendered and has to buy adequate insurance for the Gold held. The premium paid for the insurance is borne by the scheme as a transaction cost and is allowed a s an expense under SEBI guidelines. This expense contributes in a small way to the tracking error. 95 The difference between the returns given by Gold and those delivered by the scheme is known as Tracking Error. It is defined as the variance between the daily returns of the underlying (Gold in this case) and the NAV of the scheme for any given time period. Gold has to be valued as per a specific formula mandated by regulations. This formula takes into account various inputs like price of Gold in US $/ ounce as decided by the London Bullion Markets Association (LBMA) every morning, the conversion factor for ounce to Kg, the prevailing USD/ INR exchange rate, customs duty, octroi, sales tax, etc. 5.8 Creation units, Portfolio Deposit and Cash Component (an example): Let us look at the following example to understand Creation Units, Portfolio Deposit and Cash Component in detail. Assumption: 1 ETF unit = 1 gm of 99.5% pure Gold During New Fund Offer (NFO) Amount Invested (Rs.): 5000 Price of 1 gm of Gold (Rs.): 1000 Since 1 ETF unit = 1 gm of Gold Issue Price (Rs.) = 1000 Units Allotted (Number = Investment/ Issue Price): 5 Creation Units 1 Creation Unit = 100 ETF units NAV (Rs.) = 1050 Price of 1 gm of Gold (Rs.): 1000 So, 100 Units will cost (Rs.) = 1050 * 100 = 1,05,000 100 ETF will be equal to 100 gm of Gold Therefore, value of Portfolio Deposit (Rs.) = 1000 * 100 = 1,00,000 Hence Cash Component (Rs.) = 1,05,000 – 1,00,000 = 5,000 Thus it can be seen by depositing Gold worth Rs.1,00,000 as Portfolio Deposit and Rs. 5,000 as Cash Component, the Authorised Participant has created 1 Creation Unit comprising of 100 ETF units. Let us now see how the Authorised Participant ensures parity between the NAV and market price of the ETFs. As can be well understood, the price of ETF will be determined by market forces, and although it is linked to the prices of Gold, it will not mirror the exact movements at all given points of time. This will happen due to excess buying or selling pressure on the ETFs, due to which prices may rise or fall more than the Gold price. Such exaggerated movements provide opportunity for arbitrage, which the APs exploit and make risk less gains. This process also ensures that prices of ETF remain largely in sync with those of the underlying. Consider a case where the demand for ETFs has increased due to any reason. A rise in demand will lead to rise in prices, as many people will rush to buy the units, thereby putting an upward pressure on the prices. This can be explained by the following example 96 Price of Gold (Rs. / gm) = 1000 NAV (Rs.) = 1050 CMP of ETF units (Rs.) = 1200 In such a situation an AP will buy Creation Units and sell ETFs in the market. To purchase 1 Creation Unit, he will have to deposit Gold worth Rs 1,00,000 (Price of Gold * number of ETF units in Creation Units * gm per ETF) as Portfolio Deposit with the custodian and balance Rs. 5,000 as Cash Component with the AMC. Once he has the Creation Unit, he will sell individual ETF units in the market at Rs. 1200/ unit, thereby making a profit of Rs. 150 (1200 - 1050) per unit. As he buys physical Gold the price of Gold will increase. Similarly as he sells fresh ETF units in the market, the supply of ETFs will increase. These two actions will lead to increase in Gold prices and reduction in ETF prices, thereby removing the anomaly in the prices of the ETF units and the underlying. Similarly, if ETF prices fall way below the price of Gold, APs will buy ETF units cheap and redeem them in Creation Unit lot size. Such an action will reduce supply of ETFs from the market and increase the supply of physical Gold (Gold held with Custodian will come into the market). Both these actions will help align prices of underlying and ETF units as ETF prices will increase due to buying (and subsequent cutting of supply) and price of physical Gold will reduce due to fresh supply in the market. 5.9 Salient Features Debt funds are funds which invest money in debt instruments such as short and long term bonds, government securities, t-bills, corporate paper, commercial paper, call money etc. The fees in debt funds are lower, on average, than equity funds because the overall management costs are lower. The main investing objective of a debt fund is usually preservation of capital and generation of income. Performance against a benchmark is considered to be a secondary consideration. Investments in the equity markets are considered to be fraught with uncertainties and volatility. These factors may have an impact on constant flow of returns. Which is why debt schemes, which are considered to be safer and less volatile have attracted investors. Debt markets in India are wholesale in nature and hence retail investors generally find it difficult to directly participate in the debt markets. Not many understand the relationship between interest rates and bond prices or difference between Coupon and Yield. Therefore venturing into debt market investments is not common among investors. Investors can however participate in the debt markets through debt mutual funds. One must understand the salient features of a debt paper to understand the debt market. Debt paper is issued by Government, corporates and financial institutions to meet funding requirements. A debt paper is essentially a contract which says that the borrower is taki ng some money on loan and after sometime the lender will get the money back as well as some interest on the money lent. Concept Clarifier – Face Value, Coupon, Maturity Any debt paper will have Face Value, Coupon and Maturity as its standard characteristi cs. Face Value represents the amount of money taken as loan. Thus when an investor invests 97  Rs.100 in a paper, at the time of issuing the paper, then the face value of that paper is said to be Rs. 100. For our understanding point of view, Face Value is that amount which is printed on the debt paper. The borrower issues this paper; i.e. takes a loan from the investor as per this Face Value. So, if the Face Value is Rs. 100, the borrower will take a loan of Rs.100 from the investor and give the paper to the investor. Next question is what the investor will earn from this investment. This can be found by looking at the ‗Coupon‘ of the paper. The Coupon represents the rate of interest that the borrower will pay on the Face Value. Thus, if the Coupon is 8% for the above discussed paper, it means that the borrower will pay Rs.8 (8/100 X 100)every year to the investor as interest income. It must be understood that the Face Value and the Coupon of a debt paper never change. There are some papers where the Coupon changes periodically, but again, for the moment we will ignore such paper. Since the investor will earn a fixed income (8% on Rs.100 or Rs.8 per year in our example), such instruments are also known as Fixed Income securities. Finally the question arises, for how long the borrower has taken a loan. This can be understood by looking at the ‗Maturity‘. So if the paper in our example says that the maturity of the paper is 10 years, it means that for 10 years the investor will receive Rs.8 as interest income and after 10 years, he will get his Principal of Rs.100 back. Thus now we can say, about the paper in our example that the borrower has taken a Rs.100 loan, for a period of 10 years, and he has promised to pay 8% interest annually. This is the most basic form of debt paper. There can be modifications made to the issue price, coupon rate, frequency pf coupon payment, etc., but all these modifications are out of these basic features. Interest rates can either be fixed or floating. Under fixed interest rates, the interest rate remains fixed throughout the tenure of the loan. Under floating rate loans, the rate of interest is a certain percentage over the benchmark. Example A Ltd. has borrowed against a debt instrument, the rate be G-Sec plus 3%. Therefore if the G- Sec moves up, the rate of interest moves up and if the G-Sec moves down the interest rate moves down. Prima facie debt instruments looks risk free. However two important questions need to be asked here: 1. What if interest rates rise during the tenure of the loan? 2. What if the borrower fails to pay the interest and/ or fails to repay the principal? In case interest rates rise, then the investor‘s money will continue to grow at the earlier fixed rate of interest; i.e. the investor loses on the higher rate of interest, which his money could have earned. In case the borrower fails to pay the interest it would result in an income loss for the investor and if the borrower fails to repay the principal, it would mean an absolute loss for the investor. A prospective debt fund investor must study both these risks carefully before entering debt funds. 5.10 What is Interest Rate Risk? The first risk which we discussed is known as the Interest Rate Risk. This can be reduced by adjusting the maturity of the debt fund portfolio, i.e. the buyer of the debt paper would buy debt 98 paper of lesser maturity so that when the paper matures, he can buy newer paper with higher interest rates. So, if the investor expects interest rates to rise, he would be better off giving short- term loans (when an investor buys a debt paper, he essentially gives a loan to the issuer of the paper). By giving a short-term loan, he would receive his money back in a short period of time. As interest rates would have risen by then, he would be able to give another loan (again short term), this time at the new higher interest rates. Thus in a rising interest rate scenario, the investor can reduce interest rate risk by investing in debt paper of extremely short -term maturity. Concept Clarifier – Interest Rate Risk In our example, we have discussed about a debt paper which has a maturity of 10 years and a coupon of 8%. What will happen if interest rates rise after 2 years to 10%? The investor would have earned Rs.8 for 2 years and will earn Rs.8 yet again in the 3rd year as well. But had he got the Rs. 100 with him (which he had invested 2 years ago), instead of investing at 8%, he would have preferred to invest @ 10%. Thus by investing in a long term paper, he has locked himself out of higher interest income. The best way to mitigate interest rate risk is to invest in papers with short- term maturities, so that as interest rate rises, the investor will get back the money invested faster, which he can reinvest at higher interest rates in newer debt paper. However, this should be done, only when the investor is of the opinion that interest rates will continue to rise in future otherwise frequent trading in debt paper will be costly and cumbersome. Alternatively the interest rate risk can be partly mitigated by investing in floating rate instruments. In this case for a rising interest rate scenario the rates moves up, and for a falling interest rate scenario the rates move down. 5.11 What is Credit Risk? The second risk is known as Credit Risk or Risk of Default. It refers to the situation where the borrower fails to honour either one or both of his obligations of paying regular interest and returning the principal on maturity. A bigger threat is that the borrower does not repay the principal. This can happen if the borrower turns bankrupt. This risk can be taken care of by investing in paper issued by companies with very high Credit Rating. The probability of a borrower with very high Credit Rating defaulting is far lesser than that of a borrower with low credit rating. Government paper is highest in safety when it comes to credit risk (hence the description ‗risks free security‘). 99  Concept Clarifier – Credit Risk or Risk of Default Different borrowers have different levels of credit risks associated and in vestors would like to know the precise risk level of a borrower. This is done by a process known as Credit Rating. This process is carried by professional credit rating agencies like CRISIL, ICRA etc. In India, credit rating agencies have to be registered with SEBI and are regulated by SEBI (Credit Rating) Regulations, 1999. These credit rating agencies analyse companies on various financial parameters like profitability, cash flows, debt, industry outlook, impact of economic policies, etc. based on which instruments are classified as investment grade and speculative grade. Looking at these ratings, the borrower comes to know the risk level associated with the corporate. Some of CRISIL‘s rating symbols are given below: AAA – These are the safest among corporate debentures. This rating implies investors can safely expect to earn interest regularly as well as the probability of default of their principal is as good as nil. BBB – These instruments are safe, however, in case environment changes, there is a prob ability that the coupon payment and principal repayment ability may be hampered. The above 2 ratings represent the topmost and lowest rating of investment grade securities. Anything less than BBB is termed as speculative grade. The rating grade ‗D‘ represents default. Such companies are already in default and only liquidation of assets will result in realization of principal and/ or interest. 5.13 How is a Debt Instrument Priced? Debt fund investing requires a different analysis, and understanding of basic bond market concepts is essential. There exist some relationships between yields and bond prices, between years to maturity and impact of change in interest rates, between credit risk and yields, and so on. We need to understand each of these relationships before we can start investing in debt funds. The price of an instrument (equity / bond) is nothing but the present value of the future cash flows. (for understanding the meaning of present value, please refer to NCFM module ‗Financial Markets : A Beginners Module‘). In case of bonds, there is no ambiguity about future cash flows, as is the case of equities. Future cash flows in case of bonds are the periodic coupon payments that the investor will receive. Future cash flows for equities are the dividends than the investor may receive. Bond coupon payments are known right at the beginning, whereas there is no surety about a share paying dividends to an investor. Thus different investors/ analysts have different earning projections for equities, and hence each participant has a different view on the present value of a share. Bond cash flows being known, there is no confusion about what the present value of each future cash flow should be. 100  Concept Clarifier – Compounding & Discounting Suppose an investor invests Rs.100 (initial investment) in a bank FD @ 8% for 10 years, then to calculate the amount that he will receive after 10 years, we will use the compound interest formula given below – A = P * (1 + r) t Substituting P = 100, r = 8% and t = 10 years, we get the value for A as Rs. 215.89. This process is known as compounding. Instead of calculating the final amount after 10 years, if the investor says he needs Rs.215.89 after 10 years and we know that a bank FD is offering 8% per annum, we need to calculate how much money he should invest today to reach a value of Rs. 215.89 after 10 years. Again we use the same formula, but slightly tweaked. Here we solve for P (initial investment), as against for A in the previous example. P = A / (1 + r) t Substituting A = 215.89, r = 8% and t = 10 years, we can find the value of P as Rs. 100. This process is the exact opposite of compounding and this is known as discounting. This is the process used in bond markets to find the price of a bond. We add the present values (PV) of all future cash flows to arrive at the price of the bond. The r is substituted by the Yield To Maturity (YTM) while calculating the PV of bond‘s future cash flows. An important factor in bond pricing is the Yield to Maturity (YTM ). This is rate applied to the future cash flow (coupon payment) to arrive at its present value. If the YTM increases, the present value of the cash flows will go down. This is obvious as the YTM appears in the denominator of the formula, and we know as the denominator increases, the value of the ratio goes down. So here as well, as the YTM increases, the present value falls. Concept Clarifier – YTM Yield To Maturity (YTM) is that rate which the investor will receive in case: 1. He holds a bond till maturity and 2. He reinvests the coupons at the same rate It is a measure of the return of the bond. Yield to maturity is essentially a way to measure the total amount of money one would make on a bond, but instead of expressing that figure as a Rupee amount, it is expressed as a percentage—an annual rate of return. For example, Company - ABC International Ltd.: 1. Bond purchased for Rs.950. Coupon rate 8%. Bond maturity 3 years 2. Its par value (the amount the issuer will refund you when the bond reaches maturity) is Rs.1000. 101  3. Current earning = Rs.50 (Rs.1000 – Rs.950). 4. The coupon rate is the annual interest rate paid yearly by the issuer. The YTM is calculated as follows: The above has been computed by using XIRR formula is MS Excel. In the explanation for compounding, we have assumed that the interest earned after 1 year, gets reinvested in the FD for the remaining 9 years @ 8%. Similarly the interest earned after 2 years (Interest on the initial investment plus the interest earned on the interest reinvested after 1 year) is again reinvested in the FD at the same rate of 8% for the remaining 8 years, and so on. The second point mentioned above means exactly this. This may be true for bank FDs, where we get the benefit of cumulative interest, however, for bonds; the coupon (interest income) is a cash outflow every year and not a reinvestment as in case of FDs. So there is no reinvestment here. Even if the investor receives the coupon as a cash outflow, and intends to reinvest the same, there is no guarantee that for 10 years he will be able to reinvest the coupon, each year @ 8%. Thus, YTM is based upon some assumptions (i.e. you will be reinvesting the interest earned at the coupon rate), which may not always be true. In spite of its shortcomings, YTM is an important indicator to know the total return from a bond. As mentioned earlier, price of a bond is the present value of future cash flows. Thus if all the present values go down (due to increase in YTM), then their sum will also go down. This brings us to an important relation – As interest rates go up, bond prices come down. Let us try and understand this! Let us say a bond is issued with a term to maturity of 3 years, coupon of 8% and face value of Rs.100. Obviously, the prevailing interest rates during that time have to be around 8%. If the prevailing rates are higher, investors will not invest in a 8% coupon bearing bond, and if rates are lower, the issuer will not issue a bond with 8% coupon, as a higher coupon means higher interest payments for the issuer. The cash flows for the bond and the Present Values (PVs) of these cash flows are as given below – @ 8 % discounting Year 0 Year 1 Year 2 Year 3 Pays 100 Present Value of To Receive Rs.8 : Rs.7.41 Rs.8 Present Value of To Receive Rs.8 : Rs.6.86 Rs.8 Present Value of To Receive Rs.108 : Rs. 85.73 Rs.108 102  Price = 7.41 + 6.86 + 85.73 = 100 (This is the Present Value of all the future cash flows in Year 1, Year 2 and Year 3) By using the discounting formula we can find the PVs of all the 3 cash flows. The investor will get Rs.8 as interest payment each year, whereas in the final year, the investor will also get the Rs.100 principal back (along with Rs.8 as the last interest). Here we will use 8% as the rate of discounting. This means that the investor will have to invest Rs.7.41 today @ 8% per annum for the next 1 year to get Rs.8. Similarly, he will have to invest Rs.6.86 today @ 8% per annum for the next 2 years to get Rs.8 after 2 years and finally he will have to invest Rs.85.73 @ 8% per annum for the next 3 years to get Rs. 108 after 3 years. Adding all the PVs, we get the CMP of the bond as Rs.100. (in this example we assume interest rates prevalent in the market have remained at 8% and investors are happy earning 8% by investing in this bond). Now, if interest rates in the market rise immediately to 9% after the bond is issued, we will have to use 9% as the rate of discounting (investors would like to earn 9% from this bond). In that case the cash flows and their PVs will be : @ 9% discounting Year 0 Year 1 Year 2 Year 3 Pays Rs. 97.47 Present Value of Rs. 8 : To Receive Rs. 7.34 Rs.8 Present Value of Rs. 8 : To Receive Rs. 6.73 Rs.8 Present Value of Rs. 8 : To Receive Rs. 83.40 Rs.108 Price = 7.34 + 6.73 + 83.40 = 97.47 (This is the Present Value of all the future cash flows in Year 1, Year 2 and Year 3) As can be seen, the investor will invest less today, i.e. the price of the bond will go down as the interest rates in the markets have increased. When interest rates rise in the economy, it does not translate into the coupon rate changing. As can be seen here, the investor will continue to get Rs.8; i.e. 8% of the FV of Rs.100. However, he will try to earn 9% return by adjusting his initial investment. The bond price in the market will therefore fall as the interest rates in the market goes up. Thus we can say that bond prices and interest rates move in opposite directions. Relationship between interest rates and debt mutual fund schemes : As interest rates fall, the NAV of debt mutual funds rise, since the prices of the debt instruments the mutual fund is holding rises. As interest rates rise, the NAV of debt mutual funds fall, since the prices of the debt instruments the mutual fund is holding falls. Therefore it is paramount to consider interest rate movements and security maturity 103 prior to investing in any debt instrument. 5.13 Debt Mutual Fund Schemes 5.13.1 Fixed Maturity Plans (FMP) FMPs have become very popular in the past few years. FMPs are essentially close ended debt schemes. The money received by the scheme is used by the fund managers to buy debt securities with maturities coinciding with the maturity of the scheme. There is no rule which stops the fund manager from selling these securities earlier, but typically fund m anagers avoid it and hold on to the debt papers till maturity. Investors must look at the portfolio of FMPs before investing. If an FMP is giving a relatively higher ‗indicative yield‘, it may be investing in slightly riskier securities. Thus investors must assess the risk level of the portfolio by looking at the credit ratings of the securities. Indicative yield is the return which investors can expect from the FMP. Regulations do not allow mutual funds to guarantee returns, hence mutual funds give investors an idea of what returns can they expect from the fund. An important point to note here is that indicative yields are pre-tax. Investors will get lesser returns after they include the tax liability. 5.13.2 Capital Protection Funds These are close ended funds which invest in debt as well as equity or derivatives. The scheme invests some portion of investor‘s money in debt instruments, with the objective of capital protection. The remaining portion gets invested in equities or derivatives instruments like options. This component of investment provides the higher return potential. It is beyond the scope of this book to explain how Options work. For that you may need to refer to NCFM modules ‗Financial Markets: A Beginners‘ Module‘ or ‗Derivatives Markets (Dealers) module‘. It is important to note here that although the name suggests ‗Capital Protection‘, there is no guarantee that at all times the investor‘s capital will be fully protected. 5.13.3 Gilt Funds These are those funds which invest only in securities issued by the Government. This can be the Central Govt. or even State Govts. Gilt funds are safe to the extent that they do not carry any Credit Risk. However, it must be noted that even if one invests in Government Securities, interest rate risk always remains. 5.13.4 Balanced Funds These are funds which invest in debt as well as equity instruments. These are also known as hybrid funds. Balanced does not necessarily mean 50:50 ratio between debt and equity. There can be schemes like MIPs or Children benefit plans which are predominantly debt oriented but have some equity exposure as well. From taxation point of view, it is important to note how much portion of money is invested in equities and how much in debt. This point is dealt with in greater detail in the chapter on Taxation. 5.13.5 MIPs Monthly Income Plans (MIPs) are hybrid funds; i.e. they invest in debt papers as well as equities. Investors who want a regular income stream invest in these schemes. The objective of these schemes is to provide regular income to the investor by paying dividends; however, there is no guarantee that these schemes will pay dividends every month. Investment in the debt portion provides for the monthly income whereas investment in the equities provides for the extra return 104 which is helpful in minimising the impact of inflation. 5.13.6 Child Benefit Plans These are debt oriented funds, with very little component invested into equities. The objective here is to capital protection and steady appreciation as well. Parents can i nvest in these schemes with a 5 – 15 year horizon, so that they have adequate money when their children need it for meeting expenses related to higher education. 5.14 Salient Features Liquid funds carry an important position as an investment option for individuals and corporates to park their short term liquidity. y Corporates can get a better return that they would in a bank account for a relatively acceptable level of risk. Concept Clarifier – Money Markets Term to maturity of a debt paper is one of the most important characteristic of a debt paper. Debt papers can have term to maturity of as high as 20 years and more or as low as 90 days and less. The market for short term paper; i.e. paper with less than 1 year maturity attracts numerous participants , volumes and money. This is because the demand for short term money by corporates, financial institutions and Government is huge. At the same time, there is a class of investors with which there is an availability of short term funds. Due to this constant demand and ready investors, the volumes in trades of this short- term paper have increased so much that this segment is classified as a separate segment in the debt markets and is known as Money Markets. Money Market refers to that part of the debt market where paper with with a short term maturity1 year is traded. Commercial Papers, Certificate of Deposits, Treasury Bills, Collateralised Borrowing & Lending Obligations (CBLOs), Interest Rate Swaps (IRS), etc. are the instruments which comprise this market. Liquid mutual funds are schemes that make investments in debt and money market securities with maturity of up to 91 days only. In case of liquid mutual funds cut off time for receipt of funds is an important consideration. As per SEBI guidelines the following cut-off timings shall be observed by a mutual fund in respect of purchase of units in liquid fund schemes and the following NAVs shall be applied for such purchase: where the application is received up to 2.00 p.m. on a day and funds are availabl e for utilization before the cut-off time without availing any credit facility, whether, intra-day or otherwise – the closing NAV of the day immediately preceding the day of receipt of application where the application is received after 2.00 p.m. on a day and funds are available for utilization on the same day without availing any credit facility, whether, intra -day or otherwise – the closing NAV of the day immediately preceding the next business day irrespective of the time of receipt of application, where the funds are not available for utilization before the cut-off time without availing any credit facility, whether, intra-day or 105  otherwise – the closing NAV of the day immediately preceding the day on which the funds are available for utilization. This is relevant since corporates park their daily excess cash balances with liquid funds. 5.15 VALUATION OF SECURITIES 1) All money market and debt securities, including floating rate securities, with residual maturity of up to 60 days shall be valued at the weighted average price at which they are traded on the particular valuation day. When such securities are not traded on a particular valuation day they shall be valued on amortization basis. 2) All money market and debt securities, including floating rate securities, with residual maturity of over 60 days shall be valued at weighted average price at which they are traded on the particular valuation day. When such securities are not traded on a particular valuation day they shall be valued at benchmark yield/ matrix of spread over risk free benchmark yield obtained from agency(ies) entrusted for the said purpose by AMFI. 3) The approach in valuation of non traded debt securities is based on the concept of using spreads over the benchmark rate to arrive at the yields for pricing the non traded security. a. A Risk Free Benchmark Yield is built using the government securities as the base. b. A Matrix of spreads (based on the credit risk) are built for marking up the benchmark yields. c. The yields as calculated above are Marked up/Marked-down for ill-liquidity risk d. The Yields so arrived are used to price the portfolio. Concept Clarifier – Interest accrual Suppose a 90 Day Commercial Paper is issued by a corporate at Rs. 91. The paper will redeem at Rs. 100 on maturity; i.e. after 90 days. This means that the investor will earn 100 – 91 = Rs. 9 as interest over the 90 day period. This translates into a daily earning of 9/ 90 = Rs. 0.10 per day. (assuming zero coupon) It is important to note here that although we said that the investor will earn 10 paise every day, there is no cash flow coming to the investor. This means that the interest is only getting accrued. Now if the investor wishes to sell this paper after 35 days in the secondary market, what should be the price at which he should sell? Here we add the total accrued interest to the cost of buying and calculate the current book value of the CP. Since we are adding interest accrued to the cost, this method is known as Cost Plus Interest Accrued Method. If 10 paise get accrued each day, then in 35 days, 35 * 0.10 = Rs. 3.5 have got accrued. The cost of the investor was Rs. 91 and Rs. 3.5 have got accrued as interest, so the current book value is 91 + 3.5 = Rs. 94.5 106 5.16 FLOATING RATE SCHEME These are schemes where the debt paper has a Coupon which keeps changing as per the changes in the interest rates. Thus there is no price risk involved in such paper. We know when rates go up, bond prices go down. However, if the rates increase and so also the coupon changes and increases to the level of the interest rates, there is no reason for the price of the paper to fall, as the investor is compensated by getting higher coupon, in line with the on going market interest rates. Investors prefer Floating Rate funds in a rising interest rate scenario. 5.17 WHAT IS PORTFOLIO CHURNING IN LIQUID FUNDS? A liquid fund will constantly change its portfolio. This is because the paper which it invests in is extremely short term in nature. Regularly some papers would be maturing and the scheme will get the cash back. The fund manager will use this cash to buy new securities and hence the portfolio will keep changing constantly. As can be understood from this, Liquid Funds will have an extremely high portfolio turnover. Liquid Funds see a lot of inflows and outflows on a daily basis. The very nature of such schemes is that money is parked for extremely short term. Also, investors opt for options like daily or weekly dividend. All this would mean, the back end activity for a liquid fund must be quite hectic – due to the large sizes of the transactions and also due to the large volumes. As in equities, we have different index for Large caps, Midcaps & Small caps, similarly in bonds we have indices depending upon the maturity profile of the constituent bonds. These indices are published by CRISIL e.g. CRISIL long term bond index, CRISIL liquid fund index etc. 5.18 STRESS TESTING OF ASSETS1 It is important for mutual funds to ensure sound risk management practices are applied to ensure that the portfolio of liquid funds and money market funds is sound and any early warnings can be identified: AMCs should have stress testing policy in place which mandates them to conduct stress test on all Liquid Fund and MMMF Schemes. The stress test should be carried out internally at least on a monthly basis, and if the market conditions require so, AMC should conduct more frequent stress test. The concerned schemes shall be tested on the following risk parameters, among others deemed necessary by the AMC: Interest rate risk Credit risk Liquidity & Redemption risk While conducting stress test, it will be required to evaluate impact of the various risk parameters on the scheme and it‘s Net Asset Value (NAV). The parameters used and the methodology adopted for conducting stress test on such type of scheme, should be detailed in the stress testing policy, which is required to be approved by the Board of AMC. This policy should be reviewed by the Board of the AMC and Trustees. 1 CIR/IMD/DF/03/2015 April 30, 2015 107 POINTS TO REMEMBER Debt funds are funds which invest money in debt instruments such as short and long term bonds, government securities, t-bills, corporate paper, commercial paper, call money etc. Any debt paper will have Face Value, Coupon and Maturity as its standard characteristics. Interest rates can either be fixed or floating. The interest rate risk be reduced by adjusting the maturity of the debt fund portfolio. Credit Risk or Risk of Default refers to the situation where the borrower fails to honour ei ther one or both of his obligations of paying regular interest and returning the principal on maturity. The price of an instrument (equity / bond) is nothing but the present value of the future cash flows. An important factor in bond pricing is the Yield to Maturity (YTM ). This is rate applied to the future cash flow (coupon payment) to arrive at its present value. An important relation to remember is that: As interest rates go up, bond prices come down. Fixed Maturity Plans are essentially close ended debt schemes. The money received by the scheme is used by the fund managers to buy debt securities with maturities coinciding with the maturity of the scheme. Capital protection funds are close ended funds which invest in debt as well as equity or derivatives. Balanced funds invest in debt as well as equity instruments. These are also known as hybrid funds. Monthly Income Plans (MIPs) are also hybrid funds; i.e. they invest in debt papers as well as equities. Investors who want a regular income stream invest in these schemes. Child Benefit Plans are debt oriented funds, with very little component invested into equities. The objective here is to capital protection and steady appreciation as well. Liquid funds carry an important position as an investment option for individuals and corporates to park their short term liquidity. Liquid mutual funds are schemes that make investments in debt and money market securities with maturity of up to 91 days only. In case of liquid mutual funds cut off time for receipt of funds is an important consideration. Valuation of securities is done by various methods as enumerated above in the chapter. Floating Rate Schemes are schemes where the debt paper has a Coupon which keeps changing as per the changes in the interest rates. Portoflio churning in liquid schemes happens more often due the short term nature of securities invested in. It is important for mutual funds to ensure sound risk management practices are applied to ensure that the portfolio of liquid funds and money market funds is sound and any early warnings can be identified 108  Mutual funds are collective investment schemes that pool together investors‘ money and invest with a common objective. While India is traditionally a nation of savers and investors in gold and fixed deposits, mutual funds is now gaining popularity as an investment avenue due to the various options and products offered. Mutual funds take the form of trusts, They have a three tier structure with a sponsor, an asset management company and a trust. While the sponsor floats the AMC, the trust ensures that the operations are as per the stated objective. The AMC professionally manages the money and invests the same. The assets of the mutual fund are held by a custodian. The registrars and transfer agent handle the investor records of the mutual funds. An NFO is a new fund offer, where an investor can invest in the new scheme launched by the mutual fund. The investor fills the form with the registrar or online and this is submitted to the mutual fund, which then allots the units to the investor. The investor should read the offer document carefully before investing. Investors have certain rights and obligations which they should be aware of before investing in a mutual fund. 109