IL&FS mess shows why debt fund investors should watch out for credit risk

A large part of the blame for the episode, say experts, lies with the rating agencies, who should have started downgrading IL&FS and its affiliates earlier

Besides duration, credit is the other key risk that investors bear when they invest in debt funds. In the past, too, debt funds have suffered due to payment defaults or credit downgrades in the papers of Amtek Auto, Ballarpur Industries, Jindal Steel and Power, and so on. The recent multiple-notch downgrade of the papers of IL&FS (from AAA on August 6 to D by September 17) and its group entities by ICRA should jolt investors into paying greater attention to credit risk in debt fund portfolios. 

The silver lining for investors: Twelve fund houses and 32 funds have exposure to IL&FS and its group entities. Of the total debt of Rs 910 billion that the group has, mutual funds' exposure is relatively small at Rs 22.83 billion (at the end of August). This in turn is a small proportion of the total AUM of debt funds (Rs 13.23 trillion). Moreover, mutual funds have not witnessed any payment defaults so far. There have only been delays in payment. However, due to the rating downgrades, all funds with exposure to IL&FS and its affiliates have suffered mark-to-market losses. 

Who is to blame? A large part of the blame, say experts, lies with the rating agencies, who should have started downgrading IL&FS and its affiliates earlier. This would have provided an early warning, and removed the necessity for multiple-notch downgrades at one go. 
 

Fund managers can also not entirely avoid responsibility. According to experts, one area where they appear to have failed is in monitoring the risk in shorter-duration instruments like commercial papers (CPs). In case of CPs, say experts, an A1+ rating does not signify safety because rating agencies are slow to downgrade them. “When a fund manager takes exposure to a short-term paper, he should closely monitor the company's cash flows,” says Vidya Bala, head of research, Fundsindia.com. She adds that in case of shorter-duration funds, there should not be any compromise on risk to earn higher yield. If something goes wrong, there is no time in these funds to recover from the setback. 

Regulatory changes needed: At present, barring corporate bond funds and credit risk funds, the Securities and Exchange Board of India (Sebi) does not specify how much credit risk debt funds in other categories can take. Many short and medium duration debt fund categories carry high credit risk. Sebi only specifies the duration risk they can take. “This is one lacuna that Sebi needs to address,” says Bala.

What should investors do? Investors should not hastily exit their funds that have exposure to IL&FS group papers. The mark-to-market impact has already happened and the NAVs of these funds are already reflecting the downgrade. “Currently it is a notional loss. Only if there is an actual default will investors be hit by an actual loss. If the funding plans of the company fructify, and it gets some liquidity, the mark-to-market losses will go away. So investors should wait and watch,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India. By exiting now, investors will convert their notional losses into actual ones, he adds.

In the future, investors should invest with the awareness that debt funds are not as safe as, say, fixed deposits. They should work to minimise the risks in these funds. Conservative investors, says Belapurkar, should stick to funds that have a high proportion invested in AAA and A1+ rated securities. 

 

Investors should also avoid a mismatch between the fund category they invest in and their investment horizon. If an investor with a one-year horizon invests in a credit risk fund, he will not have the time to recover from a loss. Enter these funds with at least a three-year horizon. If a credit risk fund or a medium-duration fund has a yield to maturity that is higher than that of its peers, it means that the fund is taking higher risk. In such funds, Belapurkar suggests going with a fund manager who has been managing such strategies for long, and has a dedicated team to do internal credit research. Your maximum exposure to credit-risk oriented funds (meaning those that invest 50 per cent or more of their portfolios in below AA+ rated papers) should not exceed 20-25 per cent of your total debt portfolio.  

Your investment horizon should be equal to or slightly higher than the average maturity of the fund category you invest in. If it is less than two years, go for shorter-duration debt funds. “In case of these funds, avoid investing in the chart toppers. There is no way a fund manager can earn high returns in shorter-term debt funds without taking credit risk,” says Bala.

In the future, be more alert towards credit risk. “As the industry grows, there will be diversity in terms of the credit quality of portfolios. Start distinguishing between conservative and aggressive portfolios. Also, judge for yourself, or have your advisor judge, how good is the quality of credit risk assessment done by different fund houses,” says Mahendra Jajoo, head of fixed income, Mirae Asset Global Investments. He adds that investors should pay attention not just to returns but to risk-adjusted returns. And they should go with funds having well diversified portfolios, with exposure to a single entity not exceeding 2.5-3 per cent.