Over the last few years, Mr. Virat Biyani (name changed) runs an upmarket clothes retail store in a classy locality. On one occasion, a rich man's son, a spoiled brat visited his showroom and wanted to buy a couple of dark-wash denims on credit, each costing Rs 4,000. Mr. Biyani knew the father of the teenager personally and he secretly phoned him to inquire whether it was okay for his boy to be given credit. The wealthy father was equally concerned about the buying behaviour of his child and after a long pause, He told Mr. Biyani to allow the credit purchase, "This time it's okay but if he turns up again in future with such demands, please you say NO". Agreeing to this, Mr Biyani saw the thrilled teenager off with the designer jeans.

After a couple of months, a similar incident happened but Mr. Biyani ignored the rich father's words from the last time. Mr. Biyani thought-Rich dad, though he would want to, won't turn down his only child's demand and will pay the dues anyway. Subsequently, Mr. Biyani allowed the shopaholic teen to continue to buy more stuff. When Mr. Biyani sent the bills to child's father, the ‘wealthy' father was furious for the shop owner's lack of scruples. Fear of losing business opportunities or the overconfidence in assessing the situation can make a businessman act irrationally sometimes.

In the world of finance, people entrust mutual funds with their hard-earned money but the harsh reality is many mutual funds often play Mr. Biyani...

Mutual Fund houses show similar behavioural patterns. Going by their investment strategies, it seems a few fund houses are (over)confident about their abilities as well as their assessment. They are afraid that they might even lose market share, if they don't take calculated risks. But the fact of the matter is that they aren't learning from their history, the past mistakes.

What's wrong with a few fund houses?

The Financial Express dated October 24, 2015 broke a story about the brazen behaviour of mutual funds. According to the Financial Express, "at least 29 and 60 schemes held debt securities of Hindalco and Vedanta respectively, with maturity from 2016 onward. Crisil lowered long-term credit ratings of these companies to AA- and AA in April this year."

The story highlights how mutual funds still continue to hold large proportions of debt issued by troubled companies, which have even been downgraded by independent rating agencies. Wounds of Amtek Auto are still fresh, yet mutual funds are not serious about avoiding companies with poor financials or outlook.

When Financial Express questioned the mutual fund houses about the rationale behind these investments, here's what the mutual funds had to say in response.

"Upgrades and downgrades are part of life for mutual funds which invest in corporate bonds. They are like upward and downward movement of share prices for equity funds."-Head Credit and Structured Investments at a reputed fund house.

"Just like in an equity fund, the overall performance of the portfolio is looked at, similarly in a debt fund one should look at the overall fund performance"-another person representing a reputed fund house.

To justify their actions, mutual fund houses are going to the extent of saying that they are considering the track record of promotors and trusting the cash-rich nature of the few subsidiaries of troubled companies.

Flawed Justifications...
These arguments are indefensible and to an extent lame. In light of the shady track records of a few business houses, huge investments in their debt securities for longer tenure may boomerang on fund houses.

PersonalFN believes that comparing strategies for equity with those for debt is the same as comparing apples with oranges. The motive to invest in equity is maximisation of wealth. Is it the same with debt? A sane person will disagree. If net asset value of a debt fund starts fluctuating like that of an equity fund, faint-hearted investors would have sleepless nights.

Fair assessment...
Currently, the credit environment in India is abysmal. Indian banks are still struggling with the problem of Non-Performing Assets (NPAs). Reports by independent rating agencies suggest that Indian banks are going to have no respite from bad loans in Financial Year (FY) 2015-16. At the beginning of the year, Crisil estimated that NPAs of the Indian banking sector may rise by about Rs 60,000 crore to 4 lakh crore in FY 2015-16.

On the other hand, companies with healthy balance sheets still aren't deploying large cash balances on their books to capacity additions. In many industries, utilisation is much lower than 100%. Bank credit growth has been struggling to stay in double digits. By taking various initiatives from time to time, RBI has ensured that productive sectors of the economy are not starved for credit. Under such conditions, a few companies have been taking up fresh loans incessantly from all possible sources. Due to the insignificant improvement in their businesses, companies now find it difficult to service loans already on books. The Amtek group is debt laden. Also in the case of Anil Agarwal controlled companies.

In recent times, large institutional investors have even questioned the group about the merger of cash-rich oil exploring subsidiary with a cash-strapped company. There were also concerns about the lack of guidance on how the parent company wants to utilise huge cash piles available with the subsidiary. It's amusing how some mutual funds still believe there are no governance issues with such companies.

Way ahead...
After reading this, if you have concluded that all debt funds are bad and they are not meant for you, it might be exaggeration. There are many funds that don't compromise on the quality of debt securities they invest in. High yield on junk debt doesn't lure them. You should invest in such debt funds. Before you do this, please align your time horizon and the average maturity profile of the underlying fund portfolio.

PersonalFN suggests that you should hold less than 20% of your debt-side portfolio in long term debt funds.

If you still feel unsure of which debt funds might be the best ones for you; try out debt select-the unbiased research coverage of PersonalFN on debt funds.

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