The present categorisation of debt funds is based primarily on the maturity profile of the schemes. And except for credit risk funds and corporate bond funds, the existing guidelines don't prescribe any credit rating profile for other scheme categories.

The general notion has been that schemes with shorter maturities are less risky. But the recent instances of debt fiascos have severely affected the performance of schemes with shorter maturities as well.

After all, the Net Asset Values (NAVs) of liquid and short duration funds have fallen overnight, much like those of equity funds.

According to media reports, the capital market regulator may specify acceptable credit exposure limits for each category now.

In the recent past, the mutual fund houses have been financing distressed companies, without demanding adequate securities, and perhaps without undertaking a strict credit analysis.

Flashback...

When mutual funds received huge inflows in debt schemes post demonetisation, they probably took them for granted. This is when they began to help companies refinance/rollover debts.

As the liquidity crunch in the system deepened and started impacting NBFCs and mutual funds, promoters of distressed companies struggled even to meet their short-term debt obligations, thereby, throwing even short-term debt funds in a complete disarray.

Will these potential changes make debt funds safer?

We have reiterated this-debt funds aren't risk free. The intent of market regulator is aimed at protecting investors' interest. However, the suggested changes may not make much difference to the existing situation, beyond making debt fund offerings more transparent.

In simple words, informed investors will find it easy to avoid funds betting on low-rated papers in search of higher yields. However, this won't offer a surefire solution to investors.

If the credit quality of papers already held in the portfolio deteriorates, the fund managers will have limited options to salvage the investors' capital. It's noteworthy that the debt market volume for non-government securities in the secondary market compared to the volume of securities held by mutual funds is extremely low.

This makes debt holdings illiquid in crisis times.

Under such circumstances, the question of whether or not mutual funds improve their risk evaluation processes is moot.

Here's a caution...

The present liquidity crunch doesn't seem to be a systemic problem and the former RBI Governor, Dr. Y. V. Reddy has warned against the attempts of some industry players who want to present the on-going problem as the industry-level crisis.

In reality, the overambitious promoters who chased growth excessively during advantageous times and overconfident fund managers who had lent money (as if they were bankers) are equally responsible for the present situation in debt markets.

No categorisation would help unless mutual funds stop relying excessively on the credit ratings assigned by independent credit rating agencies.

We, at PersonalFN, have been warning our investors and readers against investing in any debt fund schemes that has invested in troubled companies.

Some responsible media houses have been vehemently writing about the Auditor-Promoter nexus. The unfolding IL&FS story is unmasking the false safety of debt funds. We have caught credit rating agencies napping while some so-called top rated companies were crumbling under pressure, haven't we?

All these factors point at the difficulties involved in credit evaluation. Gullible investors pushed into debt funds by intermediaries (distributors/advisers), who presented debt funds as an alternative to fixed deposits, have been the biggest losers.

What investors shall do?

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 the scheme's defined objectives, among others things.

You should invest only in debt schemes offered by mutual fund houses that follow robust investment processes and have adequate risk management systems in place.

Moreover, if you are a conservative investor, restrict your investments to schemes investing only in high-quality papers. You should consider your financial goals, risk appetite, and time horizon before investing in any debt-oriented schemes and adhere to personalised asset allocation.

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