Many parts of India are facing severe drought this year. In some regions, residential areas are getting municipal water supply only twice or thrice in a month. March is here, and it is going to be tough to sustain water supply for the next 2 ½ months until the monsoon. When there’s a scarcity of clean water supply, the only option people have is to switch to bottled water which is unaffordable to many. Those who cannot afford the expensive water have no alternative but to rely on tanker supplies. This is a cheaper alternative but you always have to deal with problems such as the higher proportion of dissolved salts or at times even contaminants. Of course, we are unsure about the source of the water, but questioning the level of hygiene seems insensible. How can we expect it to be pure? Some people do the smart thing they use bottled water for drinking purpose, and for other activities use water supplied by tankers and other sources. However, what would you do when even bottled water is impure?

Investors in debt mutual fund schemes might ask themselves similar questions very soon. The investment climate around them is horrifying. Companies are defaulting, banks are slashing interest rates on deposits (keeping the lending rates more or less unchanged)and, investing in insecure deposits is always risky. Good quality debt securities have become scary and assessing the risk has become demanding. Under such a scenario, many investors prefer to take the mutual fund route and invest in debt schemes. As the professionals manage the portfolios, investors believe that their hard earned money is in safe hands. However, startling revelations like the one is given below prove to be nasty surprises for them.

ICRA, an independent rating agency has found that more than 20% of total holdings under debt oriented schemes of mutual funds are of substandard quality. Mutual Funds, collectively, have the exposure of over Rs 2 lakh crore to debt instruments with poor credit quality. The proportion of such securities has increased by four percentage points, from 19% to 23%during February 2015 to February 2016. Financial Express dated March 28, 2016, reported the story.

Surprisingly, the list of fund houses that have a high proportion of average quality debt in their portfolios include some reputed names such as Franklin Templeton Mutual Fund, SBI Mutual Fund, UTI Mutual Fund and DHFL Pramerica Mutual Fund. They individually have about 1/4th of their debt assets in policies with poor qualities.

Reasons why low-grade securities in debt fund’s portfolios are on the rise?
 

• High exposure to mutual funds to individual securities/sectors
• Greater inflows in debt schemes on the back of RBI slashing the policy rates
• Shift in focus of fund managers from duration funds to accrual funds
• The worsening financial condition of companies engaged in businesses that are affected by the global economic slowdown.

The voice of Clarity

To understand the third point mentioned above here’s a clarification. As you know, there’s an inverse relation between interest rates and the bond prices. Fund managers try generating returns by combining the two. One, by earning interest that accrues, and two, by selling the bonds at a higher price. These are called capital gains. A fund manager of the duration fund focuses on earning capital gains by selling securities in the secondary debt markets. In other words, here, the fund manager takes active calls on the movement of interest rates. Given that, of late, the RBI has taken the “surprise element” out of monetary policy; the latter has become more predictable. Targeting inflation makes the monetary policy more objective than subjective. As the RBI has adopted the accommodative policy for some time, there’s little sense in taking active calls on interest rates. As a result, the fund managers have shifted their focus to accrual funds which tend to hold the security till it matures. This involves doing an in-depth and extensive analysis of the securities they wish to include in the portfolios.

Lured by the higher yields offered by the poor quality securities, fund houses seem to have undermined the level of risk involved in such propositions. PersonalFN has been writing about heightened risk levels in debt funds.

It is a worrying factor that the proportion of low-grade securities is on the rise even as the Securities and Exchange Board of India (SEBI) has tweaked the exposure guidelines applicable to mutual funds. PersonalFN covered this story here.

Should you stop investing in debt funds?

Yes, you should; only if you believe you should stop drinking water because the available source is undependable. You would still need water, won’t you? Similarly, there’s no reason to doubt the concept of debt mutual funds just because a few of them have exposed their investors to undue risk.

Your best bet is to seek better alternatives and avoid those funds that compromise on risk management. PersonalFN releases reports providing investor guidance on debt funds. You can be rest assured about the unbiased nature of this service.

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