Investigate steep decline in a debt fund's AUM as it can spell trouble

After massive redemption, exposure to poor-quality, illiquid papers can rise to unacceptably high levels

Debt mutual funds (MFs) have once again been hit by downgrades and defaults in debt papers of two companies — Altico Capital and Reliance Business Broadcast News Holdings (RBBNH). Fund houses have a cumulative exposure of Rs 537.67 crore to Altico Capital’s bonds, and of Rs 947.37 crore to the bonds of RBBNH and related entities (August 31, 2019 figures). Net asset values of funds exposed to these papers have seen erosion.    

Altico Capital is a non-banking financial company that is paying the price for its heavy exposure to the real estate sector. As for RBBNH, the group has been wrestling with a heavy debt burden.

According to experts, investors need to follow a simple time horizon-based investment framework in debt funds. Match your investment horizon with the time frame required for investing in each category of debt fund. If your horizon is short, stick to liquid, ultra-short or low-duration funds.

“An investor with a one-year time frame should not get into products like credit risk or medium-duration funds, which take credit risk or hold illiquid papers,” says Vidya Bala, co-founder, Redwood Research. Such funds require an investment horizon of three years or above. Even if these funds are hit by a credit default, the investor can hold on to the fund and allow his returns to normalise over time, or gain from recovery of dues (DHFL and Essel have returned money to MFs).

Many fixed maturity plans (FMPs) have been hit by these recent defaults. Investing in a closed-end product can be risky, more so if it has a longer tenure. “Investors should have the option to exit any product that carries even a small amount of risk,” says Bala. Do not think of FMPs as being as safe as fixed deposits (FDs). Those who invest in a one- or two-year FMP should ensure from the scheme information document that it will invest only in AAA-rated or government debt.

Many fund houses have gone for side-pocketing after the recent defaults. By segregating the bad assets into a separate portfolio, side-pocketing reduces the risk of further redemptions from the main portfolio. Deciding to stay in such a fund is decided by two factors. If you need the money, cut your losses and exit. But if you decide to stay, make sure the main portfolio does not hold poor-quality papers.

Some investors advise their clients to opt for bigger-sized funds. “Bigger-sized funds are less likely to suffer from concentration risk,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Securities and Exchange Board of India-registered investment advisor. A well-diversified fund is less affected by a single default. Moreover, when a default occurs in a smaller fund and the fund manager faces redemption pressure, he is forced to sell his higher-quality holdings which are more liquid. This can raise the concentration of poor-quality papers to unacceptably high levels in smaller funds.  

Stop further investments and investigate if you witness a steep decline in a debt fund’s asset under management. Sometimes, it is a signal that the more informed institutional investors have got wind of trouble at the fund.  

Check or take an advisor’s help to check the portfolio quality of any debt fund you hold or plan to invest in. A good-quality portfolio means one that has exposure to AA+ and AAA papers. Also, do not blindly invest based on high returns in the past, as those returns may have come due to the fund manager taking higher credit or interest-rate risk.  

Retirees, who are dependent on their fixed-income portfolios for regular income, should avoid risky categories of debt funds altogether. Those in the lower tax bracket may be better off sticking to FDs.