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So, why do investors continue to have confidence in banks?

This may be a reason...

Barring a few exceptions of co-operative banks, none of the prominent banks have gone belly-up and defaulted on their liabilities.

However, the same investors react differently to their investments in debt funds.

As you may be aware, some debt mutual fund schemes have witnessed high-profile defaults in the recent past, which has resulted in investors becoming wary of them.

The fall in the Net Asset Value (NAV) because of these defaults isn't the only reason. Ever since the subsidiaries of IL&FS defaulted, the investors' sentiments have altered tremendously. Let alone novice investors, even many seasoned investors are unsure how many corporates are vulnerable to financial instability and which fund will declare delinquencies in the future.

So how are they responding to their worries?

Net inflows in debt funds...

Month	Liquid and Ultra Short Term Funds   (Rs crore)	Income Funds   (Rs crore)	Gilt Funds   (Rs crore)
Aug-18	1,71,108	-6,520	-283
Sep-18	-2,11,050	-32,504	-968
Oct-18	55,296	-37,642	-291
Nov-18	1,36,135	-6,518	61
Dec-18	-1,48,906	-3,407	6
Jan-19	58,637	2,080	-89

(Source: AMFI)

By and large, investors are shunning income funds and parking their savings in liquid and ultra-short term funds.

According to the AMFI data, investors have withdrawn a massive Rs 84,511 crore from income funds and invested Rs 61,220 crore in liquid and money market mutual fund schemes over last six months.

As quoted by Economic Times dated 14 February 2019, investors have pulled out their money from long-term debt funds such as credit risk funds and dynamic bond funds, among others.

Is it a wise strategy to replace long-term debt funds in your portfolio with short-term debt funds?

Undoubtedly no!

It's true that the maturity profile of the underlying debt portfolio significantly affects the interest rate risk involved in investing in them. Thus, long-term debt funds are exposed to higher interest rate risk as compared to short-term debt funds. However, the same yardstick isn't always right for default risk, especially in the present investment climate.

In the recent past, there have been instances wherein corporate houses failed to honour even their short term debt obligation.

What's the reason?

Many of them raised new loans to repay the old ones. But with debt markets experiencing a liquidity crunch, many of them failed to roll over their debt.

Short-term debt funds aren't a defence strategy against default risk if the fund manager isn't recognising the risk, acknowledging it, and taking prudent steps to protect investors' interest.

According to Moneylife, mutual fund houses have more than Rs 16,000 crore exposure to IL&FS, DHFL, and Essel Group companies. You would be surprised to know that some funds with shorter maturities have invested substantial part of their portfolio in DHFL papers.

As per the portfolio disclosed on 31^st January, 2019, DHFL Pramerica Ultra Short Term Fund has invested 35% of its assets in DHFL papers while the exposure of JM Short Term Fund, JM Low Duration Fund, and BOI AXA Ultra Short Term Fund has been 22%, 22%, and 14% respectively.

Moreover, since Yield-to-Maturity (YTM) on some debt instruments DHFL issued has shot up to 22%, fund houses such as Baroda Mutual Fund and UTI Mutual Fund recently increased their stake in the troubled housing finance company.

How safe do you now think investing in short-term debt funds is?

Not very safe, right?

Debt fund investors investing in short-term debt funds considering them safe haven't become wiser.

[Read: Why Debt Funds Aren't Safe And Can't Guarantee Fixed Returns]

Here's what investors should do to safeguard their investments in debt funds...

Although the situation is slightly tricky, given the unusual uneasiness in the credit markets at present, investors need not panic. Unless, there's any official announcement on delinquencies, redeeming investments from the schemes offered by affected fund houses based on speculated news is unwarranted.

In the wake of the diminishing credit quality lately, fund managers of responsible fund houses might have already started taking corrective measures. This includes, paring exposure to low-rated papers, not relying excessively on independent credit agencies, and realigning their portfolios keeping in mind scheme's defined objectives among others.

Moreover, conservative investors will restrict themselves to schemes investing only in high-quality papers.

Please remember:

• Investing in debt funds isn't risk-free.

• Do not invest in schemes only because they have outperformed their benchmarks in the recent past.

• Consider your financial goals, risk appetite, and time horizon before investing in any debt-oriented scheme.

• Following your personalised asset allocation is the key.

• Ideally, you should invest only in schemes that have a maturity profile resembling with your time horizon, to avoid unpleasant surprises.

• Last but not the least, invest only in debt schemes offered by mutual fund houses that follow robust investment processes and have adequate risk management systems in place.

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Happy Investing!

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