Worried about your debt fund?

By Morningstar |  28-01-20 | 

We urge readers to consult with a financial adviser before investing. What we offer are just broad suggestions.

I invested in UTI Dynamic Bond Fund for more than 2 years. The returns are negative. Should I exit? They invested in Dewan Housing NCD. What are the implications?

- Ram

The UTI Dynamic Fund has been yielding negative returns over the past couple of years owing to their exposure to a few stressed papers. Though they don’t hold any investments in the parent companies (IL&FS and Wadhawan Global Capital), they do carry some exposure to IL&FS SPV (Special Service vehicle) as well as DHFL (a housing finance company that comes under Wadhawan Group).

A series of defaults have impacted the Indian debt market significantly over the past couple of years. The fall in returns may put many investors in panic mode and prompt them to take hasty decisions, and the most obvious one would be to exit the impacted funds. However, we would like to advise you to adopt a more measured approach towards this situation. The fund house is at various stages of resolution with respect to the impacted debt papers and redeeming might entail incurring actual losses.

It is important for you to see if this fund continues to meet your requirement and is in line with your risk appetite. You can continue to hold on to your investment if that is the case, considering that they fund house may be able to recover the losses that they have taken onto their books, as and when a resolution is arrived at. Having said that, we strongly urge you to speak to your financial adviser to evaluate this fund’s ‘fit’ in your portfolio.

Among the following debt funds, which is the best from return and safety point of view: 1) Corporate bond fund 2) Banking and PSU debt fund 3) Short term debt fund 4) Arbitrage fund.

- Ravi

When evaluating risks in a debt fund, you need to think about two primary risks – Interest rate risk and credit risk.

Interest rate risk is the sensitivity of the prices of the underlying portfolio bonds to interest rate movements, these are inversely related. i.e. As interest rates go down, bond prices appreciate and vice versa. The interest rate sensitivity is expressed as the Macaulay Duration of a portfolio, higher this number the more interest rates sensitive the fund is. i.e. Both upsides and downsides will be greater depending on interest rate movements.

The second risk is credit risk. i.e. the inherent credit riskiness of the underlying bonds. This can typically be viewed by the credit breakup of the portfolio. Lower the credit ratings, greater the chances of a default/downgrade, etc.

Amongst the fund categories you have mentioned, the mandates of these are different.

  • Corporate Bonds Funds

These funds need to necessarily invest at least 80% of their portfolio in AA+ and above rated corporate bonds. Given this mandate, the credit risk in the portfolio is relatively lower, although the remaining 20% could be invested into lower rated instruments, thus it is important to study the underlying credit breakup of the portfolio. Interest rate risk is typically lower as most corporate bonds issuances are in the short to medium maturity bucket.

  • Banking & PSU Bonds Funds

These funds need to invest 80% of their portfolio in Bank CDs and PSU Bonds. Given this mandate these funds have relatively low credit risk. Although interest rate risk may be higher depending on the maturity of the PSU Bonds they hold. Given the current interest rate regime, the yields on these portfolios are lower as interest rates at the shorter end have come off as have PSU Bond spreads.

  • Short Duration Funds

These funds need to maintain a Macaulay duration between 1-4 years and thus have limited interest rate risk. But there is no defined credit mandate for this category and there are funds within this category that invest in lower yielding bonds. Thus, it is prudent to evaluate the underlying credit breakup of funds and picking a fund that matches your risk return profile.

  • Arbitrage Funds

These are not debt funds. They enter into Cash-Futures arbitrage trade, by buying the stock and shorting the future of the stock (if trading at a premium), by doing so they lock-in the profit on a trade as on futures expiry the spot and futures prices will converge. The returns on these funds is typically driven by the cash-futures spreads that are available on various cash-futures pairs, this tends to be in the ballpark of the “cost of carry”, which will vary depending upon short term interest rates. These funds are relatively safe as the arbitrage profit is locked-in on the day of the trade and doesn’t get affected by the intra month price movement of the stock.

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Feb 13 2020 07:10 PM
So which is the best MF out of the four from safety and return point of view according to you?
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