Why investing in well-diversified debt funds is a smarter choice

While portfolio concentration can boost the returns of equity funds, it offers no benefit in case of bond funds

Debt mutual funds have come under the scanner over the past one year — a rather disappointing one due to defaults by the Infrastructure Leasing and Financial Services (IL&FS) and others companies. Corporates have defaulted on their obligations towards mutual funds even in the past. Some of the names that come to mind are those of Ballarpur Industries, Amtek Auto, and Jindal Steel & Power. But the recent spate of defaults, including names like IL&FS, Zee Entertainment Enterprises, Dewan Housing Finance Corporation, Reliance-ADAG group companies and Altico capital, coming one after the other in quick succession, has awakened investors to the risks in debt-fund investing. 

Paying the price for asset-liability mismatch: Multiple factors have led to the slew of corporates defaults witnessed over the past year or so. IL&FS, an infrastructure giant, was a complex web of more than 300 companies. Its default last year had a domino effect on many companies. Though most of the others that have defaulted since then have no monetary relationship with IL&FS, the latter’s default led to a liquidity squeeze in the system and affected lending by non-banking financial companies (NBFCs) especially. As Warren Buffett has said: “Only when the tide goes out do you realise who has been swimming naked.” Something similar happened with some corporates and NBFCs. So long as the times were good, everybody danced to the music. But as soon as there was a liquidity squeeze in the aftermath of the events of September 2018, several companies and NBFCs were not able to roll over their short-term papers. Asset-liability mismatch in NBFCs was a key factor responsible for defaults by some of them. 

A collective failure: The next question that arises is: Who is to blame for these defaults? Are fund managers to blame for holding poor-quality debt papers? Are credit rating agencies responsible for being lax and not changing the ratings of these companies quickly enough as their finances deteriorated? Are credit rating agencies not regulated tightly enough? All the parties mentioned above must share the blame to some extent, since it is the collective responsibility of all stakeholders to protect investors’ wealth. 

Regulations tightened: Besides depending on credit rating agencies, fund houses need to build strong internal credit research capabilities to be able to spot trouble when it is at a nascent stage. Now the regulations have also been tightened, and this will certainly help the industry deal with similar problems in a better manner in the future. The regulator, the Securities and Exchange Board of India (Sebi), has stipulated that at least 20 per cent of the corpus of liquid funds must be invested in liquid assets. This will allow these funds to deal with the redemption pressures that arise in the wake of a default. 

Regulations now also allow side pocketing in debt schemes in case of a default. What this effectively does is separate the papers of companies that have defaulted from the good ones. Redemption is restricted in the pocket that holds these papers. This has the potential to stem the tide of redemption that funds, which have suffered a default, often face.

Some categories of debt mutual funds will always take credit risk in pursuit of higher returns. A few of the corporates that funds have invested in will default even in the future. There is nothing wrong with funds taking risks so long as these risks are clearly defined and communicated to the investors in those categories. Just as banks have non-performing assets (NPAs), mutual funds will also have some investments in corporates that default or defer repayment.

Do the due diligence: Investors need to examine closely the portfolios of funds they plan to invest in. Large exposure to a particular corporate group can be risky. Look for funds that are well diversified and have exposure to a large number of corporates. Portfolio concentration has the potential to offer benefits in the case of equity schemes, but none at all in debt funds. The less concentrated a portfolio, the more your risks are diversified. Furthermore, the returns are not compromised because the deviation in returns of AAA-rated companies is usually not much (IL&FS was an exception that offered much higher yield compared to other AAA-rated companies).

If the investor’s primary goal is to preserve capital and earn a reasonable rate of return on it, then he should stick only to overnight and liquid fund categories. On the other hand, if he wants to earn an alpha of 100-150 basis points (bps) compared to bank fixed deposits or liquid funds, and is willing to take credit risk, then he may look at credit risk funds and other such categories. 

A final word on what debt mutual funds are up against in India. Here, they have to compete against instruments offered by the government and the Reserve Bank of India (RBI). Some of the schemes that the government offers, like Employees Provident Fund (EPF), Public Provident Fund (PPF), National Savings Certificate (NSC), and others, or RBI Savings (Taxable) Bonds give returns in the range of 7.75-8.60 per cent. 

Of course, an investor needs to consult a financial advisor to optimise his portfolio in the matter of his liquidity and taxation needs (which debt funds can fulfil). Nonetheless, why would an investor take market, interest-rate, and credit risk when he has so many risk-free options that offer higher yields? Only last week, the Labour Ministry notified that the interest rate on EPF would be 8.65 per cent for 2018-19, compared to 8.55 per cent a year ago. If in a declining interest-rate scenario, the government is willing to increase the rate of return on EPF, then it becomes very difficult for several debt fund categories to compete against these instruments. 

Tips for choosing the right funds

• Your investment horizon must at least be equal to or higher than the average duration of the fund category you invest in

• Except in case of credit risk funds and corporate bond funds, the regulator does not define how much credit risk other categories of debt funds can take 

• Hence, take a close look at the quality of papers in your portfolio, or get an advisor to do so

• The bulk of your debt fund investments should be in funds that take neither credit nor duration risk

• Stick to funds that do not invest more than 3 per cent of portfolio in a single company or group

The writer is a fund manager with PPFAS Mutual Fund. Views are personal