Don’t Give Up on Debt Mutual Funds, They Are Important

By Avnish Jain

Debt mutual funds were safe – or everyone thought they were until the IL&FS episode. Suddenly, debt funds started gaining notoriety as downgrades or defaults hit them with regularity in a slowing economy, before falling into the clutches of the COVID-19 pandemic and subsequent lockdown. Cracks have appeared in debt funds since the IL&FS episode in 2018, resulting in risk aversion in sectors like NBFCs, real estate and structured products.

Credit funds were the hardest hit. Certain other categories highly rated in credit or structured assets were also affected. The cracks widened when the COVID-19 pandemic hit financial markets, raising concerns about credit default and fund liquidity. The closure of some debt plans by a large fund house has added to the woes of investors trying to cope with credit losses in recent years.

The crisis has highlighted two key risks associated with debt funds: First, credit risk or the risk of loss of interest or principal resulting from a borrower’s inability to repay debt on time. Second, the liquidity risk or the risk that a financial asset or a particular security cannot be traded quickly enough in the market without having a significant impact on the price. These two factors have emerged in recent years, ultimately leading to the forced closure of some debt funds.

Credit risk remains the main culprit, leading to the other risk when it grows. Any risk in a portfolio must be managed. However, managing credit risk is a challenge in the Indian context. There is no way to cover the credit risk. Credit Default Swaps (CDS), which are prevalent in advanced financial markets for credit risk management, have no market in India. In the event of a default, the only thing available is a legal remedy. And bankruptcy laws take time, and collecting money takes its time.

Selling a default security is not an option. The secondary corporate bond market in India is primarily for AAA / AA papers, with very low trading volume below AA. There is hardly any market for junk bonds (below the investment grade). The impact cost also increases as the rating decreases. This makes it almost impossible for a fund to offload affected assets in the event of a credit event. In the meantime, investors in the affected funds are starting to pull out, putting pressure on a fund’s liquidity. This forces the relevant fund to sell liquid papers to meet daily redemption requirements, inadvertently increasing the illiquidity of the fund.

Managing credit risk in a fund is essential as it usually leads to liquidity problems. A combination of credit risk and liquidity is powerful, as we have seen in the recent past. This could lead not only to a likely loss of capital for debt fund investors, but more importantly to a loss of investor confidence in a major investment vehicle. Prior to 2018, credit funds had grown in importance on the expectation of better returns over high-quality funds, due to higher returns in papers like credit. However, higher returns come with higher risk, which has resulted in the current situation.

Liquidity risk is not fully appreciated because it is induced by events and its impact varies. Lack of liquidity in the market could lead buyers to demand a high liquidity premium (i.e. higher yield) to give sellers the exit. This could lead the funds to sell papers for much lower prices than they might have been in normal markets. Therefore, any debt fund, especially open-ended funds, should have appropriate liquidity management policies to deal with this type of asymmetric risk. While having more in the form of cash or cash equivalents could potentially reduce fund returns in normal times, it protects investors in times of turbulence.

The recent crisis has prompted investors to question the suitability of debt mutual funds. However, debt funds continue to represent a significant part of any investor’s portfolio allocation. Although cash outflows have been observed in a large number of debt fund categories, it is foreseeable that there has been a resurgence of interest in gilt funds as well as high credit quality funds such as as corporate bonds and banking and PSU categories. The first quarter of fiscal 2021 was marked by strong entries in these categories as investors flocked to quality portfolios, a testament to investor confidence in mutual funds.

Debt mutual funds remain a good investment option for sophisticated investors. Any investment decision should be assessed on the basis of trade-offs between risk and return. Understanding key risk parameters such as credit and liquidity risk in a portfolio is important for an investor to arrive at an appropriate choice of debt mutual fund.

A detailed analysis of holdings – percentage of exposure to cash and cash equivalents, government bonds and high quality liquid papers – could give an investor insight into the credit quality and liquidity of the investor. a fund. Regular analysis (monthly or quarterly) is essential as portfolios change. An investor should monitor changes in the fund’s credit profile or liquidity profile over longer periods, to ensure that the characteristics of the fund do not undergo drastic changes from the point of investment.

Although debt funds have scared investors lately, it is still a good investment option, if care is taken in selecting a suitable fund, as is the case with any major financial decision. Recent experiences with debt should be seen as a learning curve for the investment community. Rather than giving up on an important investment option, understanding the risks and applying it to investment decisions will go a long way in building wealth for investors.

(Avnish Jain, Head of Fixed Income, Canara Robeco Mutual Fund.)

(The column is part of a series where we invite mutual fund managers and advisors to share their thoughts on debt mutual funds, their relevance to individual investors.)

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