Losing The Safety Tag- Business News
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Losing The Safety Tag

Debt funds have eroded substantial investor wealth over the past few months. Are they worth the risk?

 Renu Yadav   
Losing The Safety Tag
Illustration by Ajay Thakuri

Mutual fund assets under management have almost doubled to Rs 23.42 lakh crore in the past three years. Although the growth has been led by equity funds, the largest chunk of mutual fund money is still parked in debt funds - they account for more than half the assets and have seen 48 per cent absolute growth over the past three years, as per data provided by Icra Online. Although institutional investors are the major holders, retail investors have also been increasing their exposure to debt funds over the past few years to beat the low bank fixed deposit rates. Individual investors' share in debt funds (retail and high net worth individuals) has gone up from 28 per cent to 32 per cent in the past three years as debt fund returned more than fixed deposit rates in 2016.

All this has changed over the past few quarters. Debt mutual funds have suffered massive losses that have wiped off half the value of some funds in a single day (See Unprecedented Losses). The trigger has been defaults by some big names in the non-banking finance company (NBFC) sector and lowering of ratings of papers issued by a number of NBFCs. In fact, after IL&FS defaulted on its loans, some liquid funds (considered safe) delivered negative returns to the tune of 5 per cent in a day. This has shaken the confidence of investors. Does all this makes debt funds a bad option?

How it Started

Financial planners advise you to have some allocation to debt funds as they are less risky than equities. "The role of a debt fund is to meet short-term goals and provide a cushion to the portfolio. We need to ensure that the money invested in debt has some capital protection and liquidity," says Shweta Jain, Founder, Investography.

But recent events show that the investors have been severely underestimating the risk. It all started with IL&FS Group companies defaulting on debt, leading to downgrading of their debt papers. This made creditors cautious, which led to a credit squeeze for the entire NBFC sector. Liquidity crunch and delayed payments led to downgrade of papers of companies such as DHFL, Yes Bank, Essel Group and Reliance Group. Debt funds - whose NBFC exposure was as high as 17 per cent as on September 2018 - took a hit on net asset values. For instance, some funds with exposure to DHFL had to write off 75-100 per cent of their holdings.

In case of Essel Group, Kotak Mutual Fund asked investors to take part payment for fixed maturity plans (FMPs). HDFC Mutual Fund asked investors in FMPs to roll over their investments but recently said it would provide a liquidity of Rs 500 crore to FMPs holding non convertible debentures of Essel Group companies. This facility will be provided to FMPs which were due for redemption in April and those that will be maturing till September 2019. The fund houses are taking different measures to deal with the situation. DHFL Pramerica Fund House has merged schemes. Tata Mutual Fund has resorted to side pocketing, separating the bad assets from the main portfolio, and has given investors a 30-day "without load exit" option before starting this. UTI Mutual Fund has introduced exit load for new investors on schemes with exposure to DHFL to discourage new investments. Several fund houses have closed subscription to the affected schemes.

Could This Have Been Avoided?

Debt funds cannot avoid credit risk but limit it with better credit evaluation processes and higher allocation to high rated papers and applying caps on sectors and individual companies to reduce concentration risk.

"The exposure to lower rated papers has gone up. The credit risk that the managers have taken has risen significantly in five years. Some managers have increased their credit exposure too, resulting in a staggering increase in their exposure to non-AAA rated bonds over the five-year period," says Kavitha Krishnan, Senior Research Analyst, Morningstar India. Having said that, a lot of recent events have been triggered by liquidity crunch and not deterioration in asset quality. "Most of the papers that were downgraded were rated AAA," she added.

But there is always a scope for improvement in processes. "Risk cannot be avoided entirely, especially when events like IL& FS occur. But risk mitigation (such as covenants or making sure there is adequate liquidity) need to be in place. This is where fund managers are probably going through a learning cycle," says Vidya Bala, Head, Mutual Funds Research, FundsIndia.

But concentration risk remains. Sebi regulations prevent a fund from taking more than 10 per cent to a single issuer. However, as per the data provided by Value Research, 12 funds had over 15 per cent allocation to DHFL papers. The allocations of DHFL Pramerica Medium Term, Floating Rate and Tata Corporate Bond were 67 per cent, 53 per cent and 37 per cent, respectively, in May. This had gone up from 37 per cent, 32 per cent and 28 per cent, respectively, in April. The probable reason for the spike was that as these funds faced redemptions, the fund houses had to sell liquid papers, which increased the allocation to the illiquid papers.

Investors, too, panicked and started fleeing debt funds. This accentuated the problem. "The default led to a lot of panic selling with investors converting their notional losses into actual losses. Debt funds with exposure to the downgraded papers witnessed large redemptions which, in turn, forced fund managers to exit liquid names to meet redemption requirements, impacting other investors too," says Krishnan of Morningstar India.

What Should Investors Do

Many investors wondering if they should opt for fixed deposits again need to understand that credit risk is an inherent part of debt funds. If you want complete safety of capital, go for fixed deposits. "Debt funds can give slightly higher post-tax returns than fixed deposits," says Jain. But for that, it is better to avoid unnecessary risk.

"It is important for investors not to chase returns, especially in the short term. Boring, stable funds than chart toppers are safer. Investors who want to take higher risk should remember that equity will deliver better returns for the risk taken. Debt should preferably be used as a hedge for their equity holdings," says Bala of FundsIndia.

"It is important for investors to monitor risks such as credit quality, concentration, liquidity on a regular basis," says Bhushan Kedar, Director, CRISIL Funds Research.

@renuyadav08