The Hindu Business Line : Capital guaranteed funds — Fixed-income market needs to change

A UK-based financial consultant has underlined the relevance of capital guaranteed funds as part of a study on the mutual funds industry conducted for the Ministry of Finance. The fixed-income market in India does not, however, boast of active long-term structured products, which help capital guaranteed funds' better serve their objectives. It is, therefore, essential to widen the fixed-income product portfolio before such funds are introduced in the country.

Capital protection: Suppose an investor wants Rs 10 lakh after 15 years to pay for his child's college education. Investing in a bond fund now cannot ensure that the investor will have the required money in 15 years. The reason is that a bond fund invests in various maturities, some longer than 15 years and some shorter. Since these bonds are marked to market, the investor's cash inflow after 15 years will be based on the net asset value on the redemption date.

The capital guaranteed fund will horizon-match the bond portfolio to achieve the objective. In the above instance, the investor can choose a fund that takes exposure in only 15-year bonds. This will immunise or protect the portfolio against interest rate risk. That is, since the maturity of the bonds coincides with the investors' investment horizon, the market price of the bonds on the redemption date is not important. Rather, the purchase and redemption price of the bonds, which are known at the time of investing, determine whether investors' achieve their investment objective. To provide some capital appreciation, the fund will also take small exposure in equity.

Despite the immunising the portfolio, capital guaranteed funds might not serve the objectives of the retail investors in India. The reason has to do with the absence of an active structured fixed-income market and the not-so-high income levels of the mutual fund investor class.

Structured products: At present, the fixed-income market has only coupon-bearing bonds. Such bonds expose the investors to reinvestment risk. This is the risk of having to reinvestment the interest received every half-year at a lower rate. The reinvestment risk may prevent a capital guaranteed fund from achieving its objectives. This risk is important because such funds typically tend to be for the long term. And the reinvestment risk is higher, longer the bond maturity. So, a fund that invests in, say, 15-year bonds may not still ensure that the investor achieves his objective of earning Rs 10 lakh at the end of the investment horizon.

Introducing structured products helps lower the reinvestment risk. The easiest alternative is to invest in zero-coupon bonds (also called zeros). Since these bonds do not carry any coupon flows, the reinvestment risk is nil. Alternatively, funds should be able to swap cash flows from coupon-bearing bonds for balloon payments at the end of the investment horizon. Such a fixed-for-fixed swap would replicate the cash flows of zeros and immunise the fund from reinvestment risk. Investing in STRIPs could also mitigate the risk.

Income class: The UK consultant has suggested a close-end capital guaranteed fund. Such funds are open for subscriptions only during the IPO period. Besides, exit is possible only when the fund's investment horizon ends. The problem is that retail investors cannot really achieve their objective with such fund characteristics.

An investor wanting Rs 10 lakh in 15 years will have to invest Rs 3.70 lakh initially assuming a return of 6 per cent. That may be a heavy outlay for a retail investor. Typically, investors would like to invest small sums each month over a period of time. Similarly, a liquidity problem may force the investor to redeem the units well before the end of the investment horizon. The close-end funds do not allow the investors these flexibilities.

So, open-end funds seem a better choice given the average income levels of the retail investors in the country. But our market already has such open-end funds in the form of fixed maturity plans. As for the equity component, retail investors can directly invest in stocks or buy units in a diversified equity fund. Retail investors can, therefore, replicate the portfolio strategy of a capital guaranteed fund without much difficulty. This brings us to the conclusion that capital guaranteed funds may not offer any significant advantage to investors unless the fixed-income market structure changes.

More Stories on : Mutual Funds | Mark To Market

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
More power to paperless trade

Time to give a thrust to growth policies

Jobless recovery in US — World staring down a gun barrel

Capital account convertibility — Carefully-calibrated approach needed

Capital guaranteed funds — Fixed-income market needs to change

Gathering storm

`Hyper competition is about leveraging weaknesses' — Prof Richard D'Aveni, Amos Tuck Business School, Dartmouth College, US

IFCI merger

Forex reserves