Why It’s Time to Review Your Investment Strategy in Debt Funds?

However, the IL&FS credit crisis that unveiled in September 2018 began a new chapter - Debt Mutual Funds are Not Safe.

The IL&FS credit crisis was followed by rating downgrades and default cases of many other private entities like DHFL, Reliance ADAG Group companies, Essel Group companies, Yes Bank, Vodafone Idea, and so on. Many debt funds ended up creating a series of segregated portfolios of bad assets and saw erosion in fund values.

In a race to garner more AUM, many fund houses gave less heed to the undue risk and continued with their investments in moderate and low rated assets to generate higher yields.

The gullible investors hardly understood the significance of the crisis in private corporate bond segment until Franklin Templeton in April 2020 shut six debt mutual fund schemes overnight, having a cumulative corpus of around Rs 25,000 crore. The investors in these schemes were left stranded at the sideline with hopes of getting their money back.

As investors have the right to express themselves through their investment choices, investor preferences have recorded a shift across the category of debt funds since then.

The Franklin Templeton episode has changed investors choice of debt funds, with a significant outflow from high risk categories like Credit Risk Funds to relatively safer categories like Corporate Bond Funds and Banking & PSU Debt Funds.

Moreover, categories like Liquid Funds, Ultra Short Duration, Low Duration and Money Market Funds too have seen a significant appreciation in AUM in absolute terms.

This numbers clearly indicate that investors have become more careful and are now preferring safety over returns while investing in debt funds.

But is the new choice of fund categories really safe?

Let's find out.

As of September 2020, debt mutual funds held around 59.1% of the total corpus in corporate bonds, valued at around Rs 7,28,500 crore. Of this around Rs 85,000 crore is invested in moderate to low rated assets (i.e. AA & Below rated instruments), accounting for about 11.7% of the total AUM in corporate bonds. Moreover, around half of the top-rated corporate bonds consist of instruments issued by private issuers.

Apart from Credit Risk Funds, other debt fund categories like Medium Duration Funds, Medium to Long Duration, Dynamic Bond Funds, Short Duration Funds, Banking and PSU Debt Fund, Floating Rate Funds, etc. still carry significant allocation to moderate and low rated assets.

Even assets of shorter horizon categories like Ultra Short Duration, and Low Duration Funds have significant exposure in moderate rated assets, along with predominant allocation to instruments issued by top rated private issuers.

Is it worth taking the undue risk?

Private issuers do offer higher coupon rates, but at the same time carry additional risk. Fund managers tend to chase such instruments to top the returns chart, but at the same time expose investors to unwarranted risk.

Even investors often get carried away with debt funds that have generated higher returns or have exceptionally high Yield-to-Maturity (YTM), which in its true sense could be an indicator of additional risks taken by the fund manager.

Debt fund investors are well exposed to high credit risk instruments that could erode their wealth if such instruments turn into bad assets.

Moreover, many liquid funds are not completely safe. Liquid Funds having exposure to instruments issued by private issuers are vulnerable to credit risk, which could turn fatal if India witnesses the next wave of COVID-19 cases and another lockdown.

Do not forget that the COVID-19 cases are hitting a record daily high in the US, whereas cases are resurging in Europe too. The UK, Italy, France, and Germany have imposed new restrictions and lockdowns.

In conditions like these, it is best to stay away from liquid and debt funds having exposure to toxic assets. In my opinion, liquid funds are meant for parking investor's money safely. Fund Managers should strictly keep themselves away from private issuers and focus on safety.

If your preference is safety over returns, you need to meticulously evaluate the portfolio quality and issuer choice in the fund's portfolio.

Check if your debt fund manager is eyeing higher yields by exposing you to higher credit risk instruments issued by private issuers.

You need to reconsider your investment in debt funds that have over 20% to 25% allocation in instruments issued by private issuers. If you have a low risk appetite, then certainly such funds are not meant for you.

Editor's Note: PersonalFN's debt fund recommendation service DebtSelect is backed by a stringent rating process that gives more weightage and emphasis on the credit quality of funds portfolio, instead of performance. The funds focusing on high yielding instruments issued by moderate to low rated private issuers score low on our SMART Score matrix, and are thus rated lower.

Under DebtSelect, we now give preference to funds having high quality portfolio with focus on Government and Quasi-Government instruments. It avoids funds that aim for higher yield by taking higher credit risk with substantial exposure in instruments issued by private issuers. We consider private issuers to be more vulnerable to credit crisis, compared to Government and Quasi-Government issuers.

As a rule, we would resist from recommending funds that hold high exposure (over 20%) in instruments issued by private issuers, irrespective of ratings assigned by other rating agencies. In order to ensure safety of capital over higher yield, we would stick to funds holding major allocation to securities issued by Government and PSU entities.

Warm Regards,
Vivek Chaurasia
Editor, FundSelect

PS: If you are looking for quality mutual fund schemes, you should try PersonalFN's premium research service, FundSelect. Currently, with your subscription to FundSelect, you could also get a copy of our special report 5 Undiscovered Equity Funds; and Free access to popular debt fund recommendation service DebtSelect. Read full details here...

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