Is An All-Debt Portfolio A Prudent Option?

An analysis carried out by DSIJ shows that debt gave better risk-adjusted returns. This should certainly be of interest to a conservative investor

The coronavirus pandemic is considered to be a ‘black swan’ event where equity markets skidded almost 40 per cent in just a matter of two months. Though it recovered quite quickly and substantially, the volatility still persists as represented by India VIX.



The above graph of India VIX clearly shows how volatile markets have been since year till date (YTD). Hence, many investors are fearful of it shooting up and losing all their gains. This can also be seen from the mutual funds’ inflow and outflow data published by the Association of Mutual Funds in India (AMFI) on a monthly basis. As on July 2020, equity mutual funds collectively witnessed outflows of Rs 2,480 crore as compared to inflows of Rs 241 crore in the previous month.



As can be seen, amid a rise in volatility, investors started locking in gains by moving out of equity mutual funds. While there was so much of volatility and lack of return in the equity market, debt funds gave returns in double-digit. Therefore, the question arises if investors should opt for an all-debt portfolio? In this article, we have attempted to answer this question and also suggest what should be your course of action.

As we know, markets appear to be under a cloud of uncertainty ever since the beginning of the pandemic. It has sent markets around the world reach levels not observed since the global financial crisis of 2008. The S & P BSE Sensex and Nifty 50 crashed by 38 per cent, following the strong correlation with the indices globally. Amid this, the total loss of market cap was an astounding 27.31 per cent.

In the meantime, companies have scaled back their growth plans. Layoffs have bourgeoned and employee compensations have also been affected, resulting in negligible growth in the last couple of months. Sectors such as hospitality, tourism and entertainment have been impacted severely and stocks of such companies have plummeted by more than 40 per cent YTD.

In response to the turmoil, the Reserve Bank of India (RBI) and the Government of India have come up with a slew of reforms such as repo rate reductions, regulatory relaxation by extending moratorium and several other measures to boost liquidity in the system. The growth and health of the economic activity has weakened due to payments deferrals, subdued loan growth, surge in bad loans and lethargic business conditions.

On the other hand, the bond market had reason to cheer due to falling interest rates. However, it has also witnessed a lot of credit issues since 2018 and the recent Franklin Templeton debacle. But overall, the debt market flourished. This also might be the reason why people might wish to have an all-debt portfolio. So, without waiting any further, let’s understand whether at all it is prudent to have an all-debt portfolio.

All Debt Portfolio

To answer this question, we have carried out an analysis wherein we compared equity and debt from a long-term perspective. Then we move on to see how an all-equity and an all-debt portfolio compare with various combinations of equity and debt. We have considered CCIL All Sovereign Bond Index as the representative of debt and S & P BSE 500 to be the representative of equity. We have considered S & P BSE 500 as it includes even mid-cap and small-cap companies in addition to large-cap companies. The period of study spans from August 2005 to July 2020. It is to be noted that all the returns above the one-year period are annualized and monthly returns are considered.



The above graph clearly depicts that in one-year rolling returns, there were times when equity went below debt, but also rewarded considerably more than debt. However, in terms of volatility, debt scores over equity. There are only a few instances where debt gave negative returns.

Even the three-year rolling returns show that equity is quite volatile than debt, but rewards its investors for the risk undertaken. On the other hand, debt is less volatile and there was only one instance when it gave negative returns. However, the maximum returns that the debt generated was 14 per cent, while equity generated 27 per cent in a three-year period.



We can see that with five-year rolling returns, the volatility in equity diminishes. There were only four instances when equity gave negative returns. And in case of debt, there were no instances of negative returns. In fact, when equity falls continuously, debt performs better than equity in most instances. Interestingly, the difference between the average returns provided by equity and debt is not much. The average five-year rolling return of debt is 8.46 per cent and that of equity is 9.73 per cent.

Further, if we calculate the Sharpe ratio that takes into account the risk taken to generate such returns, then for the debt it is 1.23, whereas for equity it is 0.71. This means that debt gave better risk-adjusted returns than equity. It is to be noted that we have considered the risk-free rate to be 6 per cent.

As shown by the seven-year rolling returns graph, there are no negative return instances for debt as well as for equity. In fact, here we can see equity performing better than debt. Even the volatility in equity also seems to cool down as compared with the five-year rolling returns.

The average seven-year rolling returns of equity stood at 9.68 per cent, while for the debt it fetched 8.12 per cent. The Sharpe ratio of debt stood at 2.33 and that of equity was 1.23. Again, even in seven-year rolling returns, debt gave better riskadjusted returns than equity.

Out of 61 observations of 10-year rolling returns, debt was able to beat equity in only 17 instances or 28 per cent of the time. Therefore, the performance of equity seems better than debt and even the volatility in equity has reduced quite a bit. Equity generated average 10-year rolling returns of 9.61 per cent, while debt gave 8.12 per cent. In terms of risk-adjusted returns, equity is 1.36 and that of debt is 3.50. And purely from a risk-adjusted return perspective, debt scores over equity.

To gain more insights, let us compare an all-equity and all-debt portfolio with that of 75 per cent equity and 25 per cent debt, 50 per cent equity and 50 per cent debt, 25 per cent equity and 75 per cent debt portfolio. For illustration purpose, we have assumed Rs 1 lakh of investment in the portfolio.

Overall, we can see that all-equity and all-debt portfolio did well. On a risk-adjusted returns basis, 50 per cent equity and 50 per cent debt portfolio does better than other portfolios. However, consistency-wise, all-debt portfolio seems to be providing better risk-adjusted returns.

The above image shows the suitability of debt funds. Therefore, before investing in debt mutual funds, you need to first determine your objectives and time horizon. If your time horizon is up to three months, then it is better to invest in liquid funds. However, if it is long-term, then investing in gilt funds is more suitable.

Conclusion

From the analysis, it seems that not just in short-term but also in long-term, debt gave better risk-adjusted returns and most suited to a conservative investor who wants sound sleep. Hence, such an investor can have an all-debt portfolio. However, it must be actively managed and for this, you need to monitor quite a bit of things such as economy, RBI’s monetary policy, interest rate scenario, etc. and based on it decide in which debt funds you should park your money. Also, while selecting debt funds avoid credit risk funds and also check for debt funds’ credit profile before investing. Ensure that the fund investments are not tilted towards below AA-rated and unrated debt instruments.