Don’t abandon debt mutual funds, they are important

Debt mutual funds was safe - or everybody thought so 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 ...

ET Online
By Avnish Jain

Debt mutual funds was safe - or everybody thought so 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 been appearing in debt funds since the IL&FS episode in 2018, translating into risk aversion in sectors like NBFCs, realty and structured products.

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Credit funds were hit the hardest. Some other categories which were heavy on low-rated credit or structured assets were also hit. The cracks widened as the COVID-19 pandemic hit teh capital markets, leading to worries on credit default as well fund liquidity. Closure of some debt schemes by a large fund house added to the woes of investors trying to come to terms with credit losses in past few years.


The turmoil has highlighted two key risks associated with debt funds: One, credit risk or the risk of loss of interest or principal resulting from a borrower's inability to repay a debt obligation on time. Two, liquidity risk or the risk that a given financial asset or security cannot be traded quickly enough in the market without materially impacting the price. Both these factors have come to fore in the last few years, finally culminating in forced closure of some debt funds.

Credit risk remains the main culprit, leading to the other risk when it fructifies. Any risk in a portfolio needs to be managed. However, managing credit risk is a challenge in the Indian context. There is no way to hedge credit risk. Credit default swaps (CDS), which are prevalent in advanced financial markets for managing credit risk, do not have a market in India. In case of a default, the only thing available is legal recourse. And the bankruptcy laws are time consuming, with recovery of money taking its own time.

Selling any defaulted security is not an option. The secondary corporate bond market in India is predominantly for AAA/AA papers, with very low trading volume in anything below AA. There is practically no market for junk bonds (below investment grade). The impact cost also increases as rating goes lower. This makes it almost impossible for a fund to offload affected assets in case of any credit event. In the meantime, investors in affected funds, start exiting, putting pressure on the liquidity of a fund. This forces the affected fund to sell liquid papers to meet daily redemption requirements, inadvertently increasing the fund illiquidity.
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Management of credit risk in a fund critical as this generally leads to liquidity issues. A combination of credit and liquidity risk is potent as we have seen in the recent past. This could lead, not only to probable loss of capital for debt fund investors, but more importantly loss of faith of investors in an important investment vehicle. Prior to 2018, credit funds had gained prominence on expectation of better returns as compared to high credit quality funds, on account of higher yields in credit like papers. However, higher returns carry higher risk, which has culminated into the current situation.

Liquidity risk is not fully appreciated as it is event driven and the impact varies. Lack of liquidity in the market could potentially lead to buyers demanding high liquidity premium (i.e. higher yield) to give exit to sellers. This could lead to funds selling papers at much lower prices than what could have been in normal markets. Therefore, any debt fund, especially open-ended funds, should have appropriate liquidity management policies to deal with this kind of asymmetric risk. While having additional in the form of cash or cash equivalents may potentially reduce fund returns in normal times, it protects investors during turbulent times.

The recent turmoil has had investors asking questions on suitability of debt mutual funds. However, debt funds continue to be a major part of any investor’s portfolio allocation. While fund outflows have been there from a large number of debt fund categories, predictably there was renewed interest in gilts funds as well high credit quality funds like corporate bond and banking & PSU categories. First quarter of FY2021 saw good inflows in these categories as investors flocked to quality portfolios, pointing to the faith of investors in mutual funds.

Debt mutual funds continue to remain a good investment option for discerning investors. Any investment decision needs to be assessed on the basis of risk and return trade-offs. Understanding of the main risk parameters like credit and liquidity risk in a portfolio is important for an investor to arrive at an appropriate choice of debt mutual fund.
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Detailed analysis of holdings - percentage exposure in cash and cash equivalents, government bonds, and high-quality liquid papers - could give an investor an insight into the credit quality and liquidity in a fund. A regular analysis (monthly or quarterly) is essential as portfolios change. An investor needs to watch out for changes in the credit profile or liquidity profile of the fund over longer periods of time, to ensure that fund characteristics do not undergo drastic changes from point of investment.

While debt funds have given a scare to investors in recent times, it remains a good investment option, if due care is taken in selection of a suitable fund, as is with any important financial decision. The recent experiences in debt should be viewed as a learning for the investment community. Rather than abandoning an important investment option, understanding the risks and applying it to investment decisions will go a long way towards wealth creation for investors.
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(Avnish Jain, head 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.)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
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