The Mutual Fund Show: What Experts Make Of India's Inclusion In JPMorgan Bond Index

Inclusion of India in the JPMorgan Emerging Market Bond Index is good news, but experts warn of volatility caused by FPIs and FIIs

The Mutual Fund Show: What Experts Make Of India's Inclusion In JPMorgan Bond Index

India's inclusion in the JPMorgan Emerging Market Bond Index will have a cushioning effect on the macro-economic side but will also expose the market to volatility from foreign investors, according to experts.

The inclusion of Indian bonds in the JP Morgan index begins in June 2024 with a weight of 1%, increasing 1% each month until it reaches 10% by April 2025.

"It has a flip side in terms of volatility," said Sunil Jhaveri, founder and chairman of MSJ MisterBond. Speaking to BQ Prime, he explained that foreign portfolios and institutional investors are known for sudden entries and exits. "This will always be a negative side of the story as far as the so-called hot money is concerned."

However, the effects will have a "cushioning effect" on the macro side, like the fiscal deficit, oil prices, and balance of payments.

Jhaveri expects an inflow of about $25 billion to $30 billion over a period of ten months starting in June 2024.

Rohin Pagdiwala, CFP and founder of Pagdiwala Investments, said another $15 billion to $20 billion can flow into the local bond market from passive as well as active funds.

"An outcome of this would be that passive funds will see a better improvement in the yields, which might result in active funds having to consider investing in India as well," he said. Further, a gradual drop in borrowing costs and support for the rupee will also help with the balance of payments.

Risks For Retail Investors

According to Jhaveri, reinvestment risk lies with retail investors. He explained that once Indian bond yields soften as foreign inflows gather pace, bank deposits will quote much lower rates when they mature for retail investors.

"I don't think they are likely to participate in the rally on the possibility of capital gains from these long-duration bonds because they are not in that segment right now," he said.

Pagdiwala noted that interest rates globally as well as in India are nearing their peaks. "So, once maybe in three or six months, when the interest rate cycle starts to change and when the RBI starts to consider dropping rates, there is a clear runway for capturing gains from long-division bond funds," he said.

Watch The Full Interview Here:

Edited Excerpts From The Interview:

What are your initial reactions over India's inclusion in the JPMorgan Emerging Market Bond Index? How should a retail investor view this?

Sunil Jhaveri: So yes, it is great news and we have been waiting for this for a long time. But having said that, it has a flip side also in terms of volatility, which will be part and parcel of it because FPIs (foreign portfolio investors) and FIIs (foreign institutional investors) are known for entries and exits at sudden spurts. So, this will always be a negative side of the story as far as the so-called hot money is concerned. But for the fiscal deficit numbers, the balance of payments, all this will be positive as far as the macros are concerned for the country, because of the crude oil prices going up. This will have a cushioning effect, as and when this happens, but it is not going to happen in a hurry. So, from June 2024 onwards, slowly and steadily they are going to take it up to 10%. So, over that period of June 2024 and beyond 10 months to one year, we will have an inflow of about $25 billion to $30 billion, all positive from the macro-economic point for the country as such, but as for retail investors, I have a different take altogether. So, you know, we will discuss that.

Rohin, $24 billion is what many consider a conservative estimate, because experts are pointing out that aside from the passive flows, there will be active funds globally that will also look to ride that inflow and invest as front-runners to that money flowing in. What are your reactions to this?

Rohin Pagdiwala: I tend to agree with Sunil. Yes, passive flows will come in. I think $20 billion to $24 billion should come in just from passive funds, but there is potentially another $15 billion to $20 billion coming from other indices, other passive funds as well as active funds. An outcome of this would be that passive funds will see a better improvement in the yields, which might result in active funds having to consider investing in India as well. So, that might bring in some active money. All in all, I think a big positive for India. This is something that has been in the works for what I think a decade now. So, we will see drop in borrowing cost. Yields will also fall. Of course, it will take time but will gradually fall. It will help the rupee and help in the balance of payments. So, a lot of positives to come.

How should investors view this? Immediately after the announcement, the 10-year bond yield moved all the way down to below 7.1%. But it is back up to close to that 7.2% or at least at around 7.17%. Sunil, what are the implications for the Indian retail investor? Here, I also want to bring in the aspect of the tax treatment of bond funds because that changed not too long back.

Sunil Jhaveri: The retail investors are typically bank deposit investors. So, I don't think they have really participated in these kind of rallies as and when they happen, by investing in long-duration funds, etc., because the modified durations of long funds will definitely be on the higher side. That volatility is very difficult for retail investors to stomach. They are used to no volatility in bank deposit kind of products as far as the debt side is concerned, or even tax-free bonds where they don't look at the NAVs on a day-to-day basis, or the price movements on a day-to-day basis. So, when they invest in long-dated bonds elongated schemes, or long duration schemes, they are in for a rude shock whenever there are those ups and downs happening in their portfolios. So, I don't foresee the retail investors really benefiting from it, because of the rate reductions and the softening of the yields, then that will happen.

One big risk that I see for retail investors is the reinvestment risk. So, if they had invested in bank deposits three years, two years, or one year back, and they have captured higher yields, when the yield softens once this inflow starts, the bank deposits will definitely quote much lower rates and yields, when they mature for these retail investors. So, according to me, it is a big risk as far as retail investors are concerned. I don't think they are likely to participate in the rally on the capital gains side possibility of these long duration bonds because they are not in that segment, right now.

How should a nuanced retail investor look at this, because the options in the bond fund category are looking much less attractive post-tax than they did a short while back?

Rohin Pagdiwala: Today, with a rising interest rate environment, and probably now, a stable interest rate environment, or almost flattening out, the bond fund as a category was almost dismissed because there is no real advantage that bond funds present. Of course, there are tactical opportunities from time to time, but for retail investors, even the new ones, an FD seems to be a simpler, easier choice to make, especially when the differences of marginal point you know, 10 bps or 29 bps. Keep in mind that interest rates, globally as well as in India, are probably near their peaks. So, once maybe in three or six months, when the interest rate cycle starts to change and when RBI starts to consider dropping rates, there is a clear runway for capturing gains from long division bond funds.

So, I see an opportunity for retail investors, maybe the slightly nuanced ones or the ones that are being advised. So, there is an opportunity, but like Sunil said, it won't be there for too many people. For people who are able to pick that and time that well, yes, there will be an opportunity to make money without the kind of equity risk.

Based on the RBI's commentary in the recent monetary policy meetings, it expects inflation to come down eventually. So far, there is no expectation of another rate hike. With that in mind, would a target maturity fund kind of a product make sense at this juncture?

Sunil Jhaveri: Target maturity funds are constantly rolling down in maturity kind of products and they make a lot of sense for retail investors, especially because there is visibility of returns. So, let's assume that you capture 7.2%, 7.3% or 8% returns on the corporate bond side and you hold it for five years, you will definitely earn that 8% return, because these are going to be rolling down to their maturity.

Having said that, in between, whenever the interest rates actually soften and in the next one year, two years, or even three years down the line, when they wish to, they can exit. So, I treat these the target maturity or the constant roll down maturity products open-ended fixed maturity plans. So, they are very good as far as retail investors are concerned and that is one segment which they should be investing in, and looking at investing, because either they hold it till maturity and get the returns which they have been locked in, or in between whenever the interest rates soften, one year, two years down the line, they have the option to exit along with higher coupon and higher yield, and some capital gains also.

Any thoughts, Rohin, on the target maturity plans or any other bond scheme? 

Rohin Pagdiwala: Target maturity funds can be looked at, especially at this point where you can still lock in rates and go long, you know, for five, seven, or eight-year duration. Along with that, actively manage long duration bond funds. Examples could be ICICI Prudential long-term bond fund still might give opportunities especially in the falling interest rate environment. So, I would probably do a mix of the two, versus just doing fixed maturity funds.

Sunil, any particular schemes that you would like to highlight?

Sunil Jhaveri: The G-Sec 10-year constant maturity fund is another option for investors. If they hold it for 10 years, they will get the captured yields as they have right now, 7.2% or so. For example, between 2008 and 2018, that 10-year constant maturity G-Sec delivered almost 8.5% return. At the time of investment, the coupon was 7.93%, but it still delivered 8.5% return. And during the same period, Nifty actually delivered 7.88%, because you know, the markets were expensive on those dates.

We have seen so much money flow into the actively managed small-cap mutual funds about close to Rs 50,000 crore into mid-cap and small-cap mutual funds so far in 2023 alone. More mutual fund folios in the small-cap category than large cap, than flexi cap, only second to your ELSS. What does that tell you about the environment right now?

Rohin Pagdiwala: This is typical, herd behaviour. I think herd behaviour on the part of investors and possibly herd behaviour on the part of some intermediaries also. I think the valuations of small caps and mid caps are quite high now. So, if I was talking to a client, talking to an investor, I would probably say, listen, as long as you keep your asset allocation in mind, as long as you are true to that and if you have some monies in small caps and you can probably remain invested. But if your allocations have exceeded what was your plan mix, then I would think, the investors should rebalance their portfolios and may be move monies to a large cap on the equity side.

Many people invest through the SIP route, while others invest large amounts of money in small caps when they see an opportunity. Our poll revealed that at this juncture, most people said that they would continue with their SIPs. But I want you to talk about the time of deployment and the fact that you don't necessarily make money at quite a few junctures, if you don't choose the right time to invest.

Sunil Jhaveri: You know, investors' memories are extremely short. That is the unfortunate part. They don't learn from their own mistakes. If you remember, in 2008, if you had invested in small caps till 2016 that index did not deliver any returns for eight long years. If you invested in January 2018, the value of small-cap index was Rs 56 lakh on 23rd of March 2020, and it recovered that loss only on the 1st of June 2021. So that means from 2018 to 2021, small caps delivered no returns. So, history tells us that the way small caps go up, their accentuated losses are also equally higher.

But having said that, yes, there are opportunities if you have invested in small caps in the green zone. You define the green zone based on price-to-earnings, price-to-book, etc. I have my own algorithm based on which if you had invested in small caps in the green zone, the probability of it beating Nifty 50 is almost 85% of the time. So, you know, if you are invested in the red zone, the probability of beating Nifty 50 is only 45% of the time. So, these are the figures. And we are toying with with another ratio, which we are still in the process of analysing. Nifty small-cap 100 divided by Nifty 50, if that ratio is 0.5% to 0.65% and you have invested during that period, or less than 0.5%, in terms of the ratio, then even small caps can deliver returns for you. But if you have invested at 0.65% or higher as the ratio, the probability of earning returns will be very miniscule in the small-cap space.

Over the past several months, and in 2023 interestingly, most of the actively managed small-cap funds have not managed to beat the benchmark. What should investors bear in mind in terms of the nature of the investment into small caps, as 60% of assets under management have to be in small caps, and the pool isn't necessarily very large to invest, particularly due to the free float in some of these stocks?

Rohin Pagdiwala: What I like to look at is, of course, the performance of the fund, historical performance. You can look at rolling returns as a decent measure. You look at the alpha that the fund is able to generate over the index but apart from that you look at the even size of the fund. I mean, in small-cap funds, very large sizes are in fact probably detrimental to the performance of the fund, because these stocks are not as liquid as you mentioned. So, as an investor, you need to look at a combination of these factors. More importantly, (you need to also look at) valuations at the point of entry, like Sunil was mentioning. And, I agree with him completely that there are times when there are long periods of time, when small-cap or even mid-cap funds do not deliver positive returns. So, I stress upon the fact that if you have to invest in these and if the funds have been identified well, you still have to remain true to your asset allocation and stay within that boundary, do not excessively invest in small and mid-caps. One point I want to make here, is that the amount of money coming to small cap is typically there to chase greed and because of the last three-year returns of small-cap funds have been what 36% odd, while for mid-caps its has been about 31% odd. So, there is a tendency to chase return.

Very few investors will remember or have gone through cycles, where they would have seen more return or negative returns. So, that is why the money is coming in, because investors have a recency bias. And, they will see what the recent returns have been. But I will be very, very careful in identifying these funds, before entering them now.

What should investors do at this juncture then, if they have invested in small caps, and if they are part of their portfolio? At what point do you decide to rebalance? Is it a mathematical function?

Sunil Jhaveri: I have one of my own solutions. We have divided the markets into red, yellow, and green zones. Right now, we are not in the red zone yet, but whenever it goes into the red zone, we reduce the exposure of our equity from whatever percentage, down to 30%. So that means 70% goes into liquid funds, and then we start the value STP (systematic transfer plan) kind of a product or strategy from that liquid funds into equity going forward also.

So, what we wish to do is, we don't want to create Abhimanyu sort of equity investors, who are stuck in a chakravyu. Nobody's guiding them in terms of when to exit or when to do profit-booking. But they need to be guided on an ongoing basis, based on the market valuations. If the market valuations are expensive, please cut your positions and get back into your asset allocation. So, my simple philosophy and funda is that be 30% in equity at all points in time, create your own balance, advantage fund and when the market is going through the red zone, remove your money and take it to liquid funds and start your journey again in the equity, slowly and steadily.

What are some of the key tenets of that red zone?

Sunil Jhaveri: Red zone is Nifty price-to-earning and price-to-book. I have tried this, and it has worked wonderfully well and by the way, you know, in the last 23 years, red zone to green zone and green zone to red zones have only happened seven times. It is not happening on a daily basis.

Rohin, is it a mathematical calculation? So, for most people, they would have an asset allocation, you know, on a broader basis between fixed income and equity and within equity, you would have a sub classification.

Rohin Pagdiwala: I come from a different school of thought and this comes from my learning with clients from on a behavioural front. Most investors, if you churn their portfolios too much, tend to get nervous, they tend to get kind of edgy about their investments. I prefer to buy and hold. I would do a little rebalancing, if the asset allocation had shifted significantly. So, I will do a little rebalancing within the equity segments, from some small and mid to large and vice versa. But I would not really tamper around too much with the overall mix and let time and the markets do it for us. I wouldn't be churning too much.

But having said that, based on the kind of returns that you yourself pointed out 32% growth in small cap and the 10% for large cap. Just going by that metric, you will have a skew towards small caps in your portfolio. At what point do you decide that you need to rebalance?

Rohin Pagdiwala: So, I would look at PE as a guiding factor. So, I think small-cap PEs are now at 24-25, significantly above the long-term averages. So, I would, may be think if fresh money were coming in now, I would not allocate to small or mid. They are clearly allocated to large cap. If an investor has a significant amount of money in a small cap, then yes, I will probably rebalance a little bit. But like I said, I had like to remain invested and let investors remain invested for a long time.