Why Investing In Debt Mutual Funds Turning Riskier

Jun 08, 2020

Things have started to look better for investors in the equity market amid the reopening of economic activities. However, there seems to be no respite for investors in debt funds.

Since the September 2018 IL&FS fallout there have been multiple occasions where investors witnessed erosion in wealth due to a spate of rating downgrades and defaults. Apart from IL&FS and its group companies, Essel Group companies, Reliance ADAG companies, Vodafone-Idea, DHFL, Yes Bank among others were some of the companies that were hit by rating downgrades and defaults.

Mutual funds with significant exposure to the debt papers of these companies had to either write off their exposure or take substantial haircuts on the maturity value.

In some cases mutual fund created side-pockets for the troubled assets. The amount would be repaid to investors as and when the fund house recovers money from these assets.

As on April 30, 2020, mutual funds have nearly Rs 874 crore in the segregated portfolios, excluding those belonging to the wound schemes of Franklin Templeton. The side-pocketed exposures are mainly spread across Aditya Birla MF, Nippon India MF, Tata MF, and UTI MF.

Unfortunately, the resolution process for stressed assets has been slow and has till now seen a very low recovery rate. The lockdown could further slow down the recovery of stressed assets for AMCs.

The finance minister has announced a moratorium on fresh insolvency proceeding for at least six months (can be extended up to one year) starting March 25. Meaning a default during this period cannot be recognized by AMCs. The relaxation on resolution timelines for stressed assets would spell more troubles for debt schemes. It would affect their ability to take necessary actions to address any default situation.

Since mutual funds are not in the business of lending, they don't have a proper framework to recover their dues as compared to banks and NBFCs.

Most of the companies for which mutual funds have created segregated portfolios seem far away from finding a resolution for their debt and repaying their creditors.

Recently, Principal MF and HSBC MF decided to completely mark down exposure to DHFL as it expected continued dislocation of businesses and erosion in value of the residual business of DHFL as well as delay the insolvency and bankruptcy proceedings against the company due to the lockdown.

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Pandemic crisis has added to the pain...

Due to the pandemic related disruptions managing debt schemes has become even more challenging for fund houses. The credit risk has magnified as borrowers are facing cash flow and demand crunch. Hence, there is a strong likelihood of delay in repayment of principal and interest.

As a result, funds undertaking higher credit risk (investing in low-rated securities) may be at risk. Not just that, it is possible that debt papers that command 'AAA' rating today may be downgraded in time to come due to weak economic activity causing a credit risk contagion across the Indian mutual fund industry.

Mutual funds have substantial exposure of around 46% to papers in the banking and finance sectors. This is a cause of worry because a slowdown in economic activity and RBI's loan moratorium is likely to bring in liquidity and asset quality challenges for many firms in the sector.

To be sure, most of the assets in the portfolio have top credit rating, but as past evidence suggests, reliability of ratings is questionable.

If the non-performing assets of these firms pile-up, it will have an impact on the mutual funds holding exposure to such firms; ultimately, investors will bear the brunt.

[Read: Should Retail Investors Stay Away From Debt Mutual Funds Altogether?]

How you can save yourself from trouble brewing in debt funds

Firstly, do not assume debt funds (including short duration funds) to be safe. Debt funds are prone to credit risk, liquidity risk and interest rate risk. All the risks mentioned have intensified to the pandemic crisis though the government, SEBI and RBI have taken steps to ease some pain.

Before investing in debt funds understand the various risks involved and invest in schemes where the portfolio risk aligns with your own risk appetite and financial objective.

In addition pay attention to the following parameters:

  • The portfolio characteristics of the debt schemes;

  • The average maturity profile;

  • The corpus & expense ratio of the scheme;

  • The rolling returns;

  • The risk ratios;

  • The interest rate cycle; and

  • The investment processes & systems at the fund house

[Read: Lessons Learnt from the Debt Fund Crisis]

How to approach debt funds now

In the current volatile and uncertain market condition, only funds that own a minimum of 80% in Government of India or PSU debt papers may be considered. Stay away from those having high exposure to private issuers.

At present, short duration funds look attractive from the risk-return point of view. Therefore, prefer going with a pure Liquid Funds and/or an Overnight Fund that does not have exposure to private issuers.

Lastly, while investing in debt funds prefer the safety of capital over returns.

Alternatively, if you prefer to keep your capital safe, opt for bank fixed deposits.

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.

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Warm Regards,
Divya Grover
Research Analyst

 

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