Why debt fund investors are worried

By Larissa Fernand |  03-05-19 | 
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Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

There is no dearth of emotion or agitation in India today. Either it is the collapse of Jet Airways, fault lines developing in India’s shadow banks, the frenzy surrounding the General Elections, or bad debt that has investors on edge. Of course, the torrid summer heat does not help either.

Recently, Uday Kotak, MD & CEO, Kotak Mahindra Bank, sounded rather ominous when he stated that the next six months will be crucial in terms of how India handles its financial sector.

Saurabh Mukherjea, Marcellus Investment Managers, did not mince words when he said that the next six months will see major blow-ups and a brutal shake out in the housing finance (HFC) and non-banking financial company (NBFC) sector.

It is apparent that neither is exaggerating. It was IL&FS that first hogged the limelight. Then it was Dewan Housing Finance Corp Ltd (DHFL). Soon the Essel Group began to steal the show. This has impacted portfolios of debt funds, hybrids and Fixed Maturity Plans, or FMPs.

We addressed these issues in Morningstar’s take on the FMP debacle and What must debt fund investors do?.

Now it’s Anil Ambani’s empire that has taken centre stage. Reliance Communication has collapsed into insolvency. Reliance Broadcast Network and Reliance Big Entertainment continues on “credit watch with developing implications”. Reliance Capital gets downgraded (Bloomberg noted that Reliance Capital has invested and lent a total Rs 137.48 billion to Anil Ambani group companies). Reliance Home Finance is now rated as Default.

Investors in debt funds failed to acknowledge the risks distinctive to this asset class, namely the interest rate risk and the credit risk. It is the latter that many are grappling with now. Many chased debt funds with higher returns than their peers, without contemplating the risk that goes behind the chase for higher yield.

Around five years ago, credit risk funds constituted 5% of the overall fixed income assets under management. That figure stands at 18% today. Some fund managers have also increased credit exposure in other funds too, which has resulted in the overall industry exposure in this space to non-AAA bonds increasing from 10% in 2008 to 34% in December 2018. (This only refers to open-ended, fixed income funds).

Kaustubh Belapurkar, Morningstar India’s director of fund research, advises investors on how to proceed.

There are several debt fund categories as defined by SEBI categorization which vary as per the level of interest rate risk, credit risk and suitable time horizon for investing.

Understand the mandates of the categories and pick funds and structures which are most suitable to your return objective, your risk profile, and investment time horizon.

All funds are not uniform within a category, particularly in the duration categories where the level of credit risk can vary quite significantly. Look at each fund’s breakup of underlying credit holdings before making an investment.

You may want a higher return, but then ask yourself if you are ready to take on additional credit risk to earn that return. If the answer is a clear NO, then you are better off investing into funds that invest purely into Government securities and AAA rated bonds. If the answer is a YES, evaluate individual funds on the level of credit risk a fund takes on and choose a strategy accordingly.

Market-linked investment avenues, whether equity or fixed income, carry risks. While they can generate pleasing results under favourable market conditions, they will suffer under unfavourable conditions. Keep that in mind. Debt funds are not a risk-free investment, and FMPs are no substitutes for bank fixed deposits.

The mark-to-market impact has resulted in falling NAVs. While that has spooked you, don’t act in haste. Fund managers are actively working with the issuers in several of these stressed credits to ensure that there is recovery of payments due, though delayed. If the mark-to-market impact on fund NAVs has spooked you, have a word with your financial adviser.

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Dhruva Chatterji
May 4 2019 05:09 PM
 If there is any key learning from this whole episode is that credit risk is pretty prevalent in high credit debt funds (like liquid funds, ultrashort funds, fmps, psu debt, short term, income/dynamic bond funds etc.) which have been touted and perceived as safe investments. After all, these funds are the ones which have seen some the biggest mark to market impact till now, alongwith credit risk and some hybrid funds. But then again, credit risk and hybrid funds have a higher risk profile, and investors should be cognizant of the same.

But this kind of turbulence in high credit funds, is difficult to digest, and raises questions of systemic risk--- even though it maybe a rare event. But shows that market linked investments are subject to risk. We have seen in global financial crisis of 2008 when in the US---liquid, money market and debt funds gave large negative returns.

That is why my earlier comments on the looming risk and why it shouldnt be played down.

So hopefully a learning for all --- fund manager, investor, distributor and even regulator.

Hoping that the contagion doesnt spread and effect retail investors (but it is always good to be cautious and prepared).

Also it is quite likely that we can expect stricter norms from the regulator on debt funds in terms of concentration limits, credit exposure, disclosure etc.
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