How Safe Is Your Debt Fund?

Fixed-income investments in India are traditionally associated with bank fixed deposits (FDs). A large part of retail savings is parked in bank FDs with the perceived notion that there is no risk associated with these. But it is not necessarily the case.

Over the past 10 years, and more so since demonetisation, retail investors have increasingly invested in fixed-income funds, which have largely been the traditional bastion of institutional investors. Favourable taxation, potentially higher returns, diversification benefits and professional management are some of the key reasons behind this shift. Again, investors have flocked to fixed-income funds with the perceived notion that returns will be predictable and the funds will be relatively safe. What they have failed to realise is that fixed-income investing also involves some major risks in terms of interest rate, credit and liquidity. Credit risks have come to the fore since the IL&FS defaults in September 2018 and the more recent stress around the Essel group companies and a couple of Reliance ADAG firms.

The growth of fixed-income assets has been significant, thanks to individual investors, and several funds such as fixed maturity plans (FMPs), short-duration funds and credit-risk funds have been the biggest beneficiaries. In fact, credit-risk funds have witnessed staggering growth on the back of the higher yields these funds offer. This has resulted in credit-risk funds accounting for nearly 18 per cent of the overall open-ended fixed-income assets under management from a meagre 5 per cent five years ago. Some fund managers have also increased credit exposure in other funds, resulting in the overall industry exposure (we are referring to open-ended, fixed-income funds space) to non-AAA bonds increasing from 10 per cent in 2008 to 34 per cent in December 2018.

The managers, too, have been adding resources to credit teams and taking on more active roles in originating, structuring and monitoring of credits. But the recent stress in credit markets has put them under the scanner.

The recent events have brought to the fore the following issues:

Understanding credit risks: Have investors truly understood the underlying risk in credit funds or largely relied on past returns before investing? This is a huge concern as it leads to mismatched expectations.

Monitoring of credits: Typically, managers tend to monitor lower-rated credits more than the higher-rated ones. But given the stress in certain instruments which were earlier highly rated, this approach warrants a relook.

Structuring of credits: Having some collateral in place is a positive, but one should know what mechanisms are there to ensure that the collateral can be enforced when needed.

Fund mandates: Well-defined fund mandates which outline the typical interest rate and credit risk of each will help investors make informed choices.

Keeping in mind recent developments, fund managers are working with the issuers in several of these stressed credits to ensure that there will be recovery of the payments due, albeit delayed, so that investor interests are protected, but the mark-to-market impact on the net asset value of funds has spooked investors.

So, what should investors do? There is no one-size-fits-all solution, but it is a good time to reassess risk-return objectives and review current portfolios.

There are several types of debt funds as per SEBI categorisation, based on interest rate risk, credit risk and investment horizon. Investors need to understand the mandates of the categories and pick funds and structures which suit their risk-return goals and investment time frame. Also, not all funds are uniform within a category, especially in the duration categories where the level of credit risk can vary significantly. Investors must pay attention to all these and look at each fund's break-up of underlying credit holdings before putting in their money.

They should also ask themselves whether they are ready to take on additional credit risks to earn more? If the answer is a clear 'no', they will be better off investing in funds which only invest in government securities and AAA-rated bonds. Those with a good risk appetite should evaluate these funds based on the level of credit risk and choose a strategy accordingly.

The writer is Director of Manager Research, Morningstar Investment Adviser India