Should I invest in short term debt funds or long term debt funds?

I was listening to the Paisa Vaisa podcast on Trust AMC and got a better understanding of how mark-to-market pricing helps or hurts bond investors.

Mark-to-market pricing

Let’s imagine there are 2 mutual funds: 2YBF that invests in bonds that mature between 1 and 2 years and 1YBF that invests in bonds that mature in less than 1 year. Imagine a period of 1 or 2 years where the interest rate remains constant.

2YBF buys a 2-year bond that pays coupon (interest) of 4.5% per year. At the same time, 1YBF buys a 1-year bond that pays coupon of 4%. Remember these market rates; we’ll use these numbers later.

By the time the first year ends, the bond held by 1YBF would have matured and 1YBF will need to buy a new 1 year bond. The bond held by 2YBF is 1 year old and matures in a year from now. 2YBF cannot  invest in bonds maturing in a year or less, so this bond must be sold. 1YBF can buy this bond because 1 year maturity is what 1YBF wants.

If 1YBF buys 2YBF’s bond, it will have to pay more money than the principal + coupon that the bond will yield. The price will be set in such a way that 1YBF will get exactly 4% return, as that’s the market rate for a 1-year bond today. This is called mark-to-market pricing.

Interest rate movements and bond returns

From the above description, it might sound like buying longer duration bonds is better than buying shorter duration bonds. But it’s not that simple. Markets don’t give us more money without taking on more risk. In this specific case, 2YBF is taking on interest rate risk. If the market rate for 1 year bonds has gone up to 5% by the time 2YBF sells its 1 year bond, 2YBF will have to sell the bond at a loss.

This is how bond returns correlate with interest rate movements:

• Holding longer maturity bonds is good in a market where the interest rate remains constant or keeps falling. You lock in a higher coupon rate and hold it for a long time.
• In a market where the rate keeps rising, holding shorter maturity bonds is better. You can keep buying fresh bonds at higher and higher coupon rates.
• In a dynamic market where the interest rate fluctuates up and down, you cannot stick to a specific duration. Something like a dynamic bond mutual fund will allow the fund manager to generate alpha by tactically buying and selling. In the scenario where 2YBF had to sell the 1 year bond at a loss, the fund manager may (or may not) choose to hold that bond till maturity to avoid selling at a loss.

Does this mean dynamic bond funds are a good investment?

It’s hard to generalise like that because higher return always means higher risk. I looked at 1 year and 3 year rolling returns of a constant maturity gilt fund (which holds bonds maturing in 10 years) and 2 dynamic maturity gilt funds. While minimum return is attractive for the 10 year gilt fund, average return looks better for the dynamic maturity funds.

These funds are also volatile, and an investor who wants predictable returns would want to stick to nonvolatile funds (usually ones with maturity less than a year) or target maturity funds.

1 year rolling returns of dynamic gilt vs 10-year gilt (source: pimeinvestor.in)

3 year rolling returns of dynamic gilt vs 10-year gilt (source: pimeinvestor.in)

Career growth and inefficiency

When you start doing something new, you are usually pretty bad at it. Once you figure out how to do it right, you stop being bad. With practice, you’ll become good, and the work will become effortless. If you are rapidly growing to new heights, you won’t be spending a lot of time on such effortless tasks. You’ll keep on moving to newer problems and you will likely find yourself struggling again and again.

Image source: pxfuel.com

It’s counterintuitive, but the faster you grow, the more time you spend being inefficient. If you’re too hard on yourself for being inefficient, your growth won’t be fast. Newer challenges will make you feel bad, and you’ll involuntarily resist growth.

If you want rapid growth, you need to change the way you assess yourself. Avoid thinking “It took me 2 full days to write a short business proposal.” Such a thought causes negativity. Instead, you may think “I have finished writing my first ever business proposal. Until today I was only an engineer, but now I am growing into also becoming a businessperson.” Feed on the positives rather than focusing on the negatives.

You need to consciously derive happiness and pride from the challenges that enable your growth. If you expect yourself to be flawless every time no matter what, your growth will be slow and painful.

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PS: Implicit assumption here is that you can tell good results from bad: either you are capable of assessing it yourself or you have people who will give you reliable feedback. This post is not for people who declare victory too quickly even when the quality of their work is poor.

Using credit card rewards to increase emergency corpus

I am scared of inflation. Not just ‘aware’ of inflation and plan with inflation in mind. I am really scared of purchasing power eroding due to inflation. This fear influences all my financial plans.

I have set aside some liquid investment as my emergency fund, to manage unexpected expenses. Because I am always afraid of inflation, I have set a goal of increasing the emergency corpus by 10% every year. While having a growing corpus is reassuring, it’s not easy to add to your corpus every year. I don’t have a plan for how to fund this increase.

I got an idea last week. I use cash back credit cards that give me some cash regularly. The reward shows up as credit on the card statement, but it’s cash nonetheless. From this month on, I am going to move that money into my emergency corpus. That will not be sufficient for the target increase of 10%, but every little bit helps.

In a way, credit card cash back rewards spending. The more we spend, the more the reward is. I am taking away this “free money” from my spending budget over to my emergency corpus. I somehow feel like this is a better habit than unconsciously spending the cash back rewards.

Confused about investing in a bull market (or a bear market)?

Many years ago, I watched a video on riding motorbikes. That video said that a rider should always be willing to fall. They didn’t say the rider should want to fall, because no one wants to fall. Rather the rider should be willing to fall because falling off a motorcycle is a question of when, and not a question of if.

The same advice is appropriate for investing too.

If you’re investing in the share market, you should be willing to lose money. Notice that I am not saying you should want to lose money, because no one really wants to lose money. Rather, you should be willing to lose money. That means being prepared for when the investment does inevitably go down in value.

Image source: pixabay.com

Today we are in the middle of a raging bull market, and the price of equities is going up almost on a daily basis. What is the narrative that we hear in the media? “The market is overheated.” “The market is expensive.” “The valuations are too high.” We often hear advice to not invest large sums into equity now because the bull run can end any day. That sure sounds like sensible advice.

I haven’t witnessed a bear market yet, but I can imagine what the narrative will be in a bear market. “Don’t invest large sums into equity now because we don’t know how much further the market will fall.” “If you wait a few days/weeks/months, you can get more shares for the same money; why invest now?” Again the same advice despite the inverted market trend.

Thinking critically will reveal to us that waiting with liquid cash runs counter to the more fundamental investing advice: “don’t try to time the market, because it’s a very very hard thing to do.”

But what’s wrong with waiting? We all like a good deal, and why not wait for a bit if you can get the same asset for a better price tomorrow? Because we don’t know when we’ll get that better deal or if a better deal will ever come at all. Waiting for a better deal is actually predicting the future. Predicting the future can be a fun exercise, but do you want to bet your money on such predictions?

If you have the money today, invest it today; don’t wait for a better time that may or may not arrive. Rain or shine, continue your SIP, because the best time to invest is when you have the money to invest. Rather than trying to find the right time to enter or exit based on market conditions, spend your energy in finding the ideal asset allocation for you so that you are systemically buying low and selling high without taking too much (or too little) risk.

Index vs value investing

I came across this tweet yesterday, and I think this highlights an advantage of index investing.

In mid 2000s, NTPC came out with an IPO at 72 per share. I applied & was allotted 200 shares.
I sold them within 2-3 years of listing at 145 per share.
In last 15 years the stocks has been stuck in a range between 70 and 150

— Arvind Datta (@datta_arvind) August 21, 2021

When seen with the context of inflation, NTPC is just losing money. Losing money through such a stock is a risk an index investor systemically avoids. A value investor might hold onto NTPC hoping that the price will eventually go up. It’ll be baffling to such an investor that you’d sell off a company just because it’s stopped satisfying an arbitrary requirement. (Other than whole market indices, everything else, including Nifty 50, Sensex, and S&P 500, pick an arbitrary number of companies.)

It’s possible that a company is kicked out of the Nifty 50 index today, but joins the index again a few years later at a higher valuation. A value investor that holds onto such a company throughout the journey will be satisfied at the end. But an index investor will be selling when the company leaves the index and buying again at a higher price when the same company rejoins the index. An index investor should be comfortable with such a turn of events.

Corollary: If you are an index investor but you cannot stomach buying expensive stocks, you should reconsider your investing style. Maybe you are a value investor in your heart, but you’re investing in indices because that’s more fashionable.

PS: Investing in whole market indices does not remove this risk. I am only considering indices that pick top N companies by market cap. Vast majority of index investors in India invest in such a “top N” indices.

PPS: To be 100% clear: I don’t know anything about NTPC; I don’t even know the full name of the company. I am not claiming that NTPC is a value stock. I am only talking about a hypothetical investor who thinks NTPC is a value pick.