Lessons Learnt from the Debt Fund Crisis

May 19, 2020

Listen to Lessons Learnt from the Debt Fund Crisis

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Debt funds were always a considered a safer and liquid alternative to equity investment. However over the last few months, investors in debt market realised the hard way that is not always the case.

From a part of portfolio being segregated due to rating downgrades to the entire fund being side-pocketed due to the pandemic-related redemption pressure, investors have been through a challenging journey. No wonder investors are pulling money out from the debt market.

The outflows have been most severe in the credit risk category - Rs 19,239 crore in April and Rs 5,568 crore in March.

Credit-risk oriented funds attracted investors in the past because of the higher yield it offered. In the pandemic crisis situation, these funds have found it difficult to manage the redemption pressure because lower rated securities are difficult to liquidate in the secondary market.

A spate of rating downgrades following the IL&FS crisis coupled with economic downturn should have raised alarm bells for fund houses undertaking high credit risk. Some funds, however, continued to hold high exposure to low-rated securities.

The stress in the bond market intensified due to the pandemic as more and more companies found it difficult to repay debt obligations. Redemption by worried investors added to the problem. Eventually, all these factors contributed to Franklin Templeton MF winding up six of its debt schemes.

(Image source: photo created by snowing - www.freepik.com)

Though AMFI has assured that all mutual funds, barring one, have been able to manage day-to-day redemptions through orderly liquidation of portfolios, it has now become vital to be extra cautious while choosing debt funds for investment.

Here are important takeaways from the debt fund crisis:

  1. High Yield to Maturity (YTM) can be a sign of stress

    High YTM is often seen as an indication of high returns. But if you dig deeper into the portfolio of the fund, you may find that the high YTM could be because of risky papers in the portfolio. Low rated papers carry higher risk of default so they offer high yields to compensate the investors.

    While this strategy can be assumed in credit risk funds, there have been instances were some lower duration funds, which are expected to be less risky, invested in lower grade papers in a bid to generate high alpha. It would be better to stay away from such funds if they carry high YTM as compared to peers and if the quality of the portfolio is questionable.

  2. Concentrated exposure is a red flag

    Apart from the overall exposure to low rated papers, check if the fund has taken concentrated exposure to a single paper or a particular group company. High concentration increases the risk to the portfolio, especially if the asset is of low grade.

    In case of a credit event, NAVs of such schemes could take a huge knock due to high concentration of the asset in the portfolio. Recently, investments of Nippon India Strategic India Debt Fund in Yes Bank knocked down 25% of the Net Asset Value (NAV) of the fund in just one day when RBI imposed a moratorium on the bank.

  3. Average maturity can be misleading

    When FTMF came out with the timeline of expected payout of the respective wound-up schemes, investors wondered why there was noticeable discrepancy between the average maturity and the time taken to repay the entire amount. For example Franklin India Ultra Short Bond Fund (FIUBF) and Franklin India Low Duration Fund (FILDF) with average maturity of just 0.44 years and 1.45 years will take around 5 years to repay the entire amount.

    This is because the maturity of some underlying securities is much longer (around 4-5 years), even though the schemes belong to a low duration category. Use of put and call options for the securities also affects the actual maturity of papers.

    Additionally, redemptions in funds and borrowing levels of the funds (indicated by negative cash balance) should be looked into for signs of stress.

How to approach debt funds

Equity investment returns have slid to its 3 year ago levels. During this period, debt investment has acted as a good portfolio diversifier generating steady returns. However, selecting the right fund based on your risk appetite and investment objective is the key. It is a good time to re-assess and re-jig your portfolio to align with your personal needs and present circumstances.

In the current market, debt funds are facing heightened credit risk and liquidity challenges. Therefore, it would be prudent to focus on funds that lay emphasis on quality (even for shorter duration funds) rather than chasing high returns.

Before investing in debt funds understand the various risks involved; some categories of funds such as gilt funds carry low credit risk but are prone to interest rate fluctuations. Do note that certain risks can be managed by holding a well-diversified portfolio.

[Read: How Quantum Multi Asset Fund of Funds Protects the Downside Risk]

[Also Read: Make Mindful Choices of Mutual Fund investments in Current times]

Preferably invest in instruments issued by government and public sector enterprises, and stay away from those having high exposure to private issuers.

Choose a fund house that follows a prudent investment process and stringent risk-management system. In these uncertain times, it would be wise to stick to liquid funds and overnight funds for the fixed-income part of your portfolio because they have more liquidity and carry lower risk.

At PersonalFN, we arrive at top rated funds using our SMART Score Model. If you wish to select worthy mutual fund schemes, I recommend you to subscribe to PersonalFN's unbiased premium research service, FundSelect.

Additionally, as a bonus, you get access to PersonalFN's popular debt mutual fund service, DebtSelect.

If you are serious about investing in a rewarding mutual fund scheme, Subscribe now!


Warm Regards,
Divya Grover
Research Analyst


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