How safe are your debt funds?

When IL&FS, one of India’s largest infrastructure financiers and developers defaulted on inter-corporate deposits and bond repayments, all hell broke loose. Rating agencies downgraded the company’s credit ratings by several notches. Many debt funds that had invested in the AAA-rated bonds issued by IL&FS took a hit as the prices of the supposedly high quality paper crashed or rating agencies marked down their value.
The worry is that the problems may not be limited to IL&FS alone. The question that should concern investors is how much risk are debt funds really taking?

Funds sleeping at the wheel?

Apart from looking at the credit ratings assigned by agencies, funds also have in-house risk assessment teams to ascertain the investment worthiness of debt issuers. In the case of IL&FS, fund houses claim that the required due diligence was done and prudent norms were followed. But some funds are either guilty of relying extensively on the rating agencies, or merely scratching the surface when analysing the issuer’s financial health. Aashish Somaiyaa, CEO, Motilal Oswal Mutual Fund, says, “If there is a substantial downgrade and a default there is no doubt that somewhere the assessment of the investment has gone wrong. ” Like some others, the NAV of the fund house’s debt fund has took a hit due to the IL&FS downgrade, but it expects to be paid full proceeds on maturity. “Following set norms when investing in higher risk bonds has to be done in true spirit, otherwise mutual funds may run the same risks as banks,” says Vidya Bala, Head, Mutual Fund Research, FundsIndia.

How debt funds invest

The noticeable deterioration in credit quality of funds considered ‘safe’ is quite disconcerting. For instance, liquid funds, positioned as substitutes to savings bank account, are typically not expected to compromise on the safety aspect. Yet, a handful of these funds have taken exposure to lower-rated instruments. The rot is more pronounced in ultra-short duration and low duration funds. Several dynamic bond funds have also taken credit-based positions, adding a layer of risk apart from the interest rate risk they are already exposed to. Franklin India Dynamic Accrual, for instance, carries 80% of its portfolio in sub-AA rated paper. Apart from the high likelihood of default, liquidity is another issue with most securities rated below AA as they are not traded actively in the market. If the fund is faced with large redemptions, it may be difficult to sell such securities at a desirable price. This may force the fund to exit from more liquid, better quality securities to provide for redemptions, enhancing the risk profile of the fund. Further, some debt funds are taking high exposure to a single issuer in their portfolio, adding another layer of risk. For instance, Principal Cash Management, a liquid scheme, had ₹102 crore in IL&FS bonds as on 31 August—9.8% of all its assets. Among the fixed maturity plans, DSP FMP Series 196 37M and 195 36M both had nearly 10% of their assets invested in IL&FS group companies. This, despite Sebi putting in place limits to reduce concentration risk.

It is clear that some funds, in their hunt for higher yields, have been too flexible in their credit standards, particularly in the ultra-short and low-duration space, where credit quality should be robust given the shorter tenure of the underlying instruments. Unfortunately, this is where Sebi’s categorisation rules are also alarmingly silent. While Sebi has introduced strict rules governing the extent of duration—a measure of interest rate sensitivity—to be allowed in these funds, there is no cap on the degree of credit risk in these categories. Fund managers, however, insist that the problem is not a reflection of the entire industry. “There could be individual instances of aggressive portfolios but, in most cases, such an approach is discernible and it is for the investors to be careful,” says Swarup Mohanty, CEO, Mirae Asset Mutual Fund.

What should investors do

Credit risk is a very real part of investing in debt funds. If you are keen on higher return from your debt funds, keep in mind that it will come with a certain degree of risk. Bala asserts that instead of aiming at high returns, investors should look at getting optimal post-tax returns in debt and treat debt not as a wealth creator but as a diversifier in a long-term portfolio.