US stocks and US equity funds have been quite a hit with Indian investors in recent years. Indians invest in these funds to gain exposure to global businesses (Amazon, Alphabet, Mastercard etc). More importantly, they would like to gain an exposure to the US dollar which has appreciated steadily against the Rupee over the years.
But the risks in owning US equities have become apparent lately, with the Fed on a rate hiking spree and the US economy flirting with a recession. US stock indices have lost 12-15% in one year, while US equity funds have seen losses of 6%-12%. But there has been a sharp rise in yields on US government bonds (treasuries).
IDFC Mutual Fund’s new fund offer of a US-centric fund investing in treasury notes is designed to help Indian investors own dollar-denominated US government debt instead of US equities, thus offering the promise of high US bond yields combined with a kicker from Rupee depreciation. But what is the fund’s use case and can it deliver on returns? We think it is a complicated solution to a simple problem. Read our review.
Post the rebranding of IDFC Mutual Fund as Bandhan Mutual Fund from March 13, 2023, this fund will be known as Bandhan US Treasury Bond 0-1 year Fund of Funds.
IDFC US Treasury Bond 0-1 year Fund of Funds will reinvest your money into the US-listed JP Morgan ETFs ICAV BetaBuilders US Treasury Bond 0-1 year UCITs ETF. This complex-sounding fund is simply an ETF that invests in a basket of US treasuries with a tenure of zero to one year. Its key features based on its latest January 2023 factsheet are as follows:
This JP Morgan ETF has a short track record. But it has fared well in the last 3 years with a 6.1% CAGR (in dollar terms) compared to the 0.6% CAGR on its benchmark (ICE 0-1 year US treasuries index). This fund’s latest YTM (January 2023) was at 4.5%.
The IDFC FOF’s returns can be lower than the underlying JP Morgan ETF on account of two factors- the Indian fund’s expense ratio and its cash/liquid holdings. In addition, the Rupee’s movements against the dollar will also make for a variance. A depreciating Rupee will add to your returns from the FOF, while a rising Rupee will reduce it.
IDFC US Treasury Bond Fund of Funds (FOF) has not yet disclosed its total expense ratio (watch for the number in the NFO). But it will levy an exit load of 0.25% for redemptions within one month. IDFC Mutual Fund is shortly set to become Bandhan Mutual Fund owing to a sponsor change. The NFO is open from March 10 to March 23 after which it will trade as an open ended FOF.
The AMC and some advisors have made a case for investing in the IDFC US Treasury Bond FOF on the following counts.
Most Indian investors have portfolio that is only exposed to Indian stocks and bonds. But Indian financial markets are very small in the global scheme of things. Diversifying into other geographies can give you access to instruments that may be better placed on safety or returns. If you’re keen on geographical diversification, the US is your best bet because the US economy is the largest in the world, the US dollar is the dominant trading currency and treated as the default reserve currency by central banks.
#2 Safe haven
If you’re looking for a safe haven in times of global turmoil or recession, it’s hard to ignore the US market. The majority of global FPIs are based in the US and they flee back home with their money whenever there are signs of trouble. This flight to safety in favour of US markets and the US dollar plays out even when the epicentre of the crisis lies in the US itself. The dotcom meltdown of 1999-2000 and the global financial crisis of 2007-08 saw global investors flee emerging markets like India to put money back into US assets. This ensures that the US dollar appreciates against currencies like the Rupee whenever there’s economic trouble or crisis. The US government is rated AA plus by global rating agencies while the Indian government is rated BBB minus.
#3 Attractive US treasury yields
With inflation in the US proving stubborn and the US Fed determined to wrestle it down to 2% (the latest January CPI reading was 6.4%), US interest rates have increased at a record pace in the past year. Therefore, US 1-year treasury yields have spiked from 0.03% in May 2021 to 4.9% now (February 28 2023). Getting a 5% return from a dollar-denominated asset that is regarded the safe haven for global investors is rare event. The IDFC US Treasury Bond Fund gives you an opportunity to earn this yield.
#4 Low duration risk
Though US interest rates may keep climbing for some time, duration risk is low with this fund given the low average maturity (0.3 years currently). The US yield curve is also inverted (1-year treasuries in the US now offer higher yields than 5 or 10 year treasuries), making short term bonds a good bet.
#5 Rupee kicker
Any depreciation of the Rupee against the US dollar adds to your returns from a US-centric fund. The Indian Rupee has depreciated against the US dollar in 9 out of the last 10 years. It has also posted an average annual depreciation of about 3% over a long period. Adding a 3% return from Rupee depreciation to the prevailing yield of about 5% on US treasuries can get you to an attractive 8% return on this FOF.
#6 Avoid TCS
After changes in the latest Budget, all your remittances to overseas markets via the Liberalised Remittance Scheme (except for travel and medical expenses) will attract a tax of 20% at source. All money remitted to the US towards payments to family members, maintenance or tuition fees of children or money parked in US markets awaiting investments there, will be subject to this tax. But investing in international funds domiciled in India does not attract TCS. This fund allows you to park money in safe US bonds until you have a need for it. It also allows you to hedge against Rupee depreciation in this period.
Arguments against investing
Many of the above arguments appear compelling in theory. But we at PrimeInvestor don’t see a use-case for this FOF, and think simpler solutions exist to address your need.
#1 US yields may not sustain
The promise of a near 8% return from a ‘safe’ US fund seems to be the most convincing argument to invest, but this return expectation is skewed by recency bias. Yields on short term US treasuries have spiked in the past year due to sticky inflation and the Fed’s sharp rate hikes to deal with it. But expecting these returns to last in the long run appears unrealistic. Both inflation and interest rates go through cycles and interest rates in a developed market like the US seldom stay elevated at such high levels.
The history of US rates (comprising both of QE and pre-QE periods) tells us that yields of 4.5-5% are far from normal for the US market. Our analysis of the 25-year history of US markets from 1997 tells us that 1-year US treasuries averaged an yield of about 1.7% in this period. The data below which captures the frequency at which the annual yield on the 1-year US treasury topped 4%. It tells you that yields on short term treasuries have stayed below 1% about 58% of the time.
Yes, the Fed is currently showing no inclination to pause its hikes, leave alone cut rates. So it appears as if higher yields of 4-5% may stay put for the coming months. But at the first sign of the Russia-Ukraine war ending, the Chinese economy opening up, global supply constraints easing or US job markets weakening, market expectations will begin to build in expectations for easing inflation and a Fed rate pause or a cut. Given that short term treasury yields are super-sensitive to incoming data, it won’t take much for US yields to ease from their abnormal levels of nearly 5%. The inverted yield curve is also an abnormality that is likely to eventually get corrected.
Should these trends play out, the yield offered by the JP Morgan ETF will decline. The fund’s low average maturity (currently 0.3 years), will ensure that high-yielding securities in its portfolio are quickly replaced with new low-yielding ones. This makes it a dicey proposition to peg your long-term return expectations from this FOF to a 5% yield from US treasuries. In the long run, a yield assumption of 2% from US treasuries may be more realistic. With a 3% Rupee depreciation, this may bring the FOF return closer to 5% in the long run compared to the 8% being projected now. And this will come with a lot of volatility.
#2 Rupee decline is not a given
If you’re an Indian investor, expecting the Rupee to depreciate against the dollar in the long run is a better bet to take. As long as India runs its economy on a Current Account Deficit (more imports than exports), the local supply of dollars is unlikely to meet demand, exerting downward pressure on the Rupee.
Taking stock of 25-year data on the Rupee’s moves against the US dollar, it is evident that the Rupee has depreciated in most of the years (See table: 18 of the last 26 years), with the annual average rate of depreciation at 2.85 per cent.
But one can be fairly sure of the Rupee depreciating against the US dollar in the long run, it is quite difficult to call Rupee-Dollar moves in the short term. The Rupee has shown sharp bouts of appreciation too against the dollar after a weak spell. The rolling return data below tells us that while the Rupee usually depreciates by about 3% a year, there have been years where it has appreciated by 15% against the dollar too. Given that the Rupee has seen a particularly sharp spell of depreciation (10%) in 2022, there’s no guarantee that 2023 or 2024 will not see such a pullback.
This makes it a dicey proposition for investors to bet on Rupee depreciation adding to the returns on IDFC US Treasury Bond FOF over the next few months or a year. This makes it a doubtful parking ground for your short-term overseas money.
#3 Doubtful safe haven appeal
The above data shows that you shouldn’t be investing in this NFO for a high return, as both US treasury yields and Rupee dollar moves are difficult to call. But what about the safe haven appeal of dollar-denominated US government bonds?
Well, if safety of capital is your prime concern, investing in treasury bills issued by the Indian government is a good enough parking ground. We have a detailed article on: How to buy G-Secs on the RBI Retail Direct Platform.
Recent auctions on the RBI Retail Direct platform have seen 91 day treasury bills offer an annualised yield of 6.92%, 182 day bills offer 7.27% and 364 day bills offer 7.36%. As this is a fixed return backed by a sovereign guarantee, there need be no safety concerns. This return is high enough to take care of Rupee depreciation risks, while compensating you partly for the time value of money.
Yes, purists may argue that the Indian government is not as ‘safe’ as the American government, given that global rating agencies give India a sovereign rating of BBB minus compared to AA plus for the US. In our view, global rating agencies have their biases and there’s no reason to doubt the Indian government’s ability to honour its obligations given that India has never defaulted in its entire history as an independent country.
For Indian investors looking for safe havens, a known devil is better than an unknown angel. If you’re looking for a long-term parking ground, money market funds which invest in Indian government bonds with up to 1 year maturity, offer a good alternative too. You can also use our Prime Fund recommendations to pick out good money market and very short duration funds.