Know The Risks In Debt Mutual Funds

The turmoil in the debt funds space along with illiquidity issue in the credit markets has affected since the bankruptcy of IL&FS in September 2018. The onset of COVID-19 and the subsequent lockdown impacting the businesses has only added fuel to the fire in the credit market.

Further, in April 2020, Franklin Templeton (FT) Mutual Fund announced winding up of six of its credit-focused debt schemes. This was a rude shock to the entire debt mutual fund investors, who rushed to withdraw their investments from credit funds as well as other debt MF schemes. Although the debt-oriented categories witnessed a net inflow of `43,432 crore in April, the credit risk category, given its nature, was one of the worst hit with a net outflow of `19,239 crore during the month. Investors in credit risk funds ran for exits after FT MF incident.

The uncertainty triggered by these events in the debt markets has not only restricted the fund houses’ ability to sell the securities but has made investors question fund houses whether to continue investing in debt funds or not. “When the economy is at the bottom levels and big crisis situations happen, like what we are facing today, the corporate bond markets become very illiquid. The price discovery and the trades happen mostly in OTC market which makes the depth also very poor. If there is a downgrade in any corporate debt paper, the instrument immediately becomes highly illiquid and will find no takers, this makes the life bit difficult,” explains George Heber Joseph, CEO and CIO, ITI MF.

Lower rated papers usually have very low liquidity as they cannot be sold immediately in the market at a fair valuation in India. During times of stress, the liquidity for such lower rated papers becomes even more tight as everyone becomes risk averse and wants to lend only to higher rated corporates. As per the Morningstar note dated April 24, the FT funds were run with a clear focus towards a credit (or accrual) strategy, with significantly higher exposure to AA and A rated instruments as compared to their peers. In such a strategy the idea is to invest in high yielding bonds and stay invested till they mature. This is an appropriate approach to be practiced in such funds or strategies as the underlying securities tend to be less liquid in nature making it difficult to liquidate them in the interim.

Due to this nature of these funds, FT found it difficult to meet the redemption pressure in the recent times. “Credit-risk funds are debt funds that have at least 65 per cent investments in less than AA-rated paper. Credit risk is the risk of default in an underlying debt security that may arise from a borrower failing to make the required payments (principal or interest),” says Deepak Khurana, Performance Director for Fund Ratings and Distribution, Asia Pacific Region at Refinitiv.

Within the debt MF universe, credit funds inherently carry high credit risk as typically they invest in lower credit quality papers where the probability of default also stands higher as compared to a sovereign/AAA/AA+ issuer. “Top rated papers AAA & AA+ rated (A1+ for short term instruments) have good trading volumes and offers sufficient liquidity to investors. Lack of liquidity in low rated papers is mainly because major financial institutional buyers like banks, insurance companies have certain investment restriction with respect to dealing in below than investment grade papers. Relatively lesser interest by market participants dry up the liquidity especially in such uncertain times,” says Deepak Jasani, Head Retail Research at HDFC Securities.

As per the Motilal Oswal AMC report on Industry flow Insights, Fixed Income experience is not as bad is made out to be, as there are isolated instances of disastrous performance but between 7 per cent to 10 per cent post tax returns over last 3, 5 and 10 years is not a bad outcome.

If one looks at the table of debt mutual fund across categories returns (See Visual), credit risk fund has not given additional returns, gilt funds have beaten corporate bond and credit risk funds over the 10-year period. Also, it would be unfair to put all the blame on fund managers during such credit crisis, especially when there are instances of mis-selling and mis-buying of the products without understanding one’s own risk appetite of risk involved in such  products.

How many investors would truly know that there are 17 categories of debt mutual funds as per classified by the regulator, Securities and Exchange Board of India (Sebi). This ranges from long duration funds to overnight funds to floater funds and that is why it is crucial for investors to choose the right kind of debt funds that suits their own risk profile. But the main flaw in the system is that even today many investors think that debt funds are completely risk free. Investment in debt MFs are subject to market risks and there is no guarantee on either the principal or returns as well. Fund managers invest money in fixed income securities like bonds and debentures issued by corporates, financial institutions and governments.

This is essentially lending done to these institutions by mutual funds and hence, there exists a possibility of default and credit risk or default risk. Yet another risk that investors need to keep in mind is interest rate risk. This risk is specific to debt funds and plays out when interest rates begin to move up. “Since bond prices and interest rates are inversely proportional to each other – when interest rates go up bond prices fall and vice versa. This impact on bond prices is reflected in the Net Asset Value (NAV) of mutual funds. Besides, with these two pertinent risks in debt funds, investors should also ensure returns from these funds (adjusted for taxes) are higher than inflation, this is better known as inflation risk,” says Rahul Jain, Head, Edelweiss Personal Wealth Advisory.

Each of these risks need to be defined clearly and explained to the investors. That said, retail investors must look at the groups or business houses these funds are investing in, as it helps them understand the group’s solvency, credit and finance parameters. They should look at liquidity, volatility, predictability and returns in that order while investing in debt funds, feel experts.

“As most debt fund investors are conservative - low duration/ short term / Banking PSU categories with optimal exposure to AAA rated paper would be the ideal option. Investors investing in search of higher return (with higher risk) can consider dynamic / credit risk funds. Doing a Systematic Investment Plan (SIP) in gilt funds can be considered as a part of long-term investment goal. Shorter duration funds, especially overnight and liquid funds, are a safe bet for short-term parking and capital protection needs,” explains Jasani.

That said, as much as risk profile is important it should be aligned with one goal and time frame. Even before redemption, investors should analyse the downside risk in case of mark down of the security or in case of closure of the schemes.

“A short-time frame leaves little room for taking risks. One need not be in debt funds to earn like saving banks account returns. Their time frame should align with that of the funds they choose. It would be wise to stay away from credit for the next few quarters given the economic situation and risk of defaults. Credit risks may well be prevalent in a low-duration or ultra-short fund. So, knowing the quality of a portfolio is important,” says Vidya Bala, Co-Founder, PrimeInvestor.in.

The other thing an investor needs to be aware of is the allocation of the portfolio towards each of the corporate groups. One should take care that no scheme has a large allocation towards a particular corporate group. “Retail Investors should diligently look at the latest holding of the debt mutual fund scheme and assess the quality of the issuers, concentration of the portfolio, deproteinise coupon rates of any and  should restrict themselves to few categories schemes with high quality portfolios apart from overnight and liquid funds,” says Jimeet Modi, Founder & CEO, Samco Securities.

During the absence of the economic activities it was only corporates who were taking out money for cash management. As the uncertainty is looming large with respect to economic activities the panic redemption for high net-worth individuals and retail investors have increased. However, it is only when the lockdown is lifted that normalcy can be seen in the debt market. Till then it is crucial to stay invested. “In any scenario, it is extremely important for investors to stay the course of the intended investment tenure. Panic only causes pain. If one has done sufficient due diligence while making investments, why succumb to panic, especially when isolated cases don’t form the rule. Hence focus on asset quality and liquidity and refrain from tracking NAVs on a daily basis,” expresses Lakshmi Iyer, CIO -(Debt) & Head Products, Kotak Mahindra AMC.

As per the AMFI the redemptions have slowed down substantially in credit risk funds because of a special window of `50,000 crore provided by the RBI. Further measures taken by the Sebi deepen bond markets over the years and have allowed normal functioning of markets and growth of debt MFs, cites AMFI. The Prime minister’s announcement of economic stimulus package of `20 lakh crore on May 12 will be a big positive for the financial sector. However, these measures would be of a great help for the economy, but the bond markets have become more anxious about how the government will fund this kind of spending.

“The current pandemic and subsequent lockdowns have adversely impacted economic activity. This will impact government revenues, leading to higher fiscal deficit. This deficit will largely be tackled by higher borrowings that in turn will push up interest rates. This will negatively impact bond prices and therefore, also debt fund NAVs,” says Jain. As per experts, debt fund investors should not go by the belief - buy a fund and forget about it. For the investors it has become more imperative than ever to understand and keep in mind the risk factor associated with various debt mutual funds. As debt funds require more active management when compared to other traditional fixed income securities, your portfolio should be best evaluated in consultation with an expert.

himali@outlookindia.com