Recent cap by JP Morgan AMC reveals the underlying risks debts funds are subject to
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Are debt funds risk free?

While equities are subject to market risk, debt funds are subject to credit risk and interest rate risk

  • September 9, 2015  
  • |  
  • UPDATED   18:08 IST

The answer is no. Equities, for instance are subject to market risk, while debt funds are subject to credit risk (the risk of default by investee company) and interest rate risk (risk of mark to market loss arising from adverse fluctuations in interest rates). Hence like equities, the value of your investment in debt funds too is at risk, albeit to a smaller extent.

Infact the recent cap on redemption limit by JP Morgan Asset Management Company on its two funds reveals the underlying risks these funds are subject to. On August 28th 2015 JP Morgan AMC issued a notice stating that it is limiting redemptions in JP Morgan India Treasury Fund and JPMorgan India Short Term Income Fund to 1% of units outstanding in each scheme, on a first-come-first-served basis. Units that don't get redeemed, will be considered for redemption on the next business day, subject to the mutual fund's and its trustees' approval. The fund's returns have been impacted since then with the Short Term Income Fund's NAV falling by 3.25% and the Treasury Fund's NAV by 2%.  

So what went wrong? JP Morgan Short Term Income Fund and the treasury fund had an exposure of 11% and 6%, respectively to Amtek Auto Money Market Bonds, which has seen rating downgrade in the last one month. On August 7th 2015 CARE ratings suspended the rating assigned to the bank facilities (worth Rs 7640 crore and Rs 2000 crore worth of NCDs) of Amtek Auto as the company had not furnished the information required for monitoring of ratings.

Prior to this in May 2015 the rating was reduced from AA to AA- citing decline in financial profile of the company marked by drop in sales and profitability in Q2FY15 and aggressive pace of acquisitions made by the company in the recent past. On August 27 2015 Brickwork rating too revised the ratings on Amtek Auto to C from A+ in July 2015, citing financial problems. Any downgrade of a corporate debt paper leads to lowering of valuations of such papers, hence the NAV of the fund holding the debt.

The fund would lift the redemption limit when the valuation of Amtek bonds stabilize, which depends on the company's ability to repay the amount due on its bonds maturing on September 20th 2015.

What should investors do? According to Srikanth Meenakshi, Founder and COO, FundsIndia.com, investors should exit the fund as and when they get the chance. Fund managers, in order to seek higher yields on their portfolio to boost the fund's return make investments into these corporate papers. Amtek Auto's bond could have provided an additional 40-50 bps over other papers, he adds.

It is worth noting that a firm with a low credit rating often compensates investors by offering a higher return. So if the fund is delivering admirably, do check to see if the reason is due to a portfolio packed with relatively riskier instruments. According to Meenakshi, in such cases significant due diligence needs to be done to understand the health of a corporation, which did not happen sufficiently in the case of JP Morgan.

Although AMCs do state in their Key Information Memorandum (KIM) that they have the right to limit redemptions in certain cases, Gaurav Mashruwala, Certified Financial Planner, does not advocate such a move. "The AMCs have many other ways of raising money and hence should not hold the investors money", he says. According to Anil Chopra, Group CEO & Director, Bajaj Capital debt funds do not assure protection of either capital or returns.

"So, if an underlying investment has defaulted, there will be an impact on the NAV and investor returns or capital may be eroded to that extent", he adds. One must remember that mutual fund investments are subject to market risk. However, at times, reputed AMCs or their sponsors take the hit of such write downs on their own books instead of passing it on to investors, in order to protect their reputation. In such cases, the investors get protected to an extent.  

Choose your fund wisely According to Chopra, consistency in returns (absolute and risk adjusted and vs. Benchmark and peer set) is something investors may look at while selecting a debt fund. Another very important point is the credit quality of the fund portfolio. Similarly, a fund derives returns from two sources - capital gains and coupon (interest) payments.

Modified duration and Yield to maturity are the two parameters that have a bearing on the potential returns from a fund. Apart from these, one should also look at the expense ratio of the fund as it has a bearing on the returns of the fund. Finally, one should also see whether the fund has a track record of sticking to its mandate, or not.

Having said that investors should not get disenchanted with the entire category based on a singular incident at one AMC. Debt funds are an ideal investment vehicle for fixed income investors. Chopra would not recommend fixed deposits to investors, neither bank nor corporate deposits. Bank deposits are low yielding (more so after the recent deposit rate cuts by most banks) and tax inefficient. Corporate deposits carry default risks if they are rated low. If rated higher, the yields or coupon is low. "Moreover, they do not benefit from downsides in interest rates and come low down the order when it comes to seniority of debt", adds Chopra. Also, there are liquidity issues with corporate deposits as investors have to pay hefty penal interest in case of premature withdrawal and that too at the discretion of the company.

"With interest rates expected to come down in the near future, investors could increase maturity of debt in their portfolio by investing into duration funds now", says Rahul Goswami, CIO Fixed Income, ICICI Prudential AMC. Duration funds invest into longer duration paper, which are more sensitive to changes in interest rates. The longer the duration, the more a bond fund's price will fluctuate when interest rates change. This is ideal if one's investment horizon is more than 3 years. For short term investments, less than 6 months, investors could look at liquid, ultra short term debt and some specific low duration funds. For investment tenure of 6 months to 1 year, banking debt funds, short term debt funds in line with investment horizon would be ideal. From a 1 year to 3 year perspective investors could invest into short term debt funds and accrual funds that benefit from medium term interest rate accruals.