Debt Funds: No Safety Tag

From the NBFC liquidity crisis in 2018 to collapse of six Franklin Templeton schemes, debt funds are no longer considered safe

On April 23, US-based Franklin Templeton announced a decision to wind up six debt mutual fund schemes in India owing to the liquidity crisis in the wake of the coronavirus outbreak. The news rattled investor confidence and, on April 28, five days later, credit risk funds witnessed one of the biggest single-day redemptions - the process of selling units - with assets under management (AUM) falling by Rs 5,223 crore.

The episode busted the myth surrounding safety of debt funds. A debt fund invests in fixed income instruments such as bonds, corporate debt securities and money market instruments. In fact, credit risk funds (debt funds that mainly invest in low-rated securities giving high returns) saw a 36.53 per cent fall in AUM during April 23-May 20, the latest data released by the Association of Mutual Funds in India (AMFI) shows.

The Reserve Bank of India's (RBI's) Rs 50,000 crore liquidity window for debt funds to manage redemptions prevented contagion but another shock is likely to aggravate the situation.

We look at some of the most affected debt fund schemes and categories to help you review your investments and take necessary steps.

Investors Worst-affected

Initially, Franklin Templeton tried to manage redemption requests by selling good quality paper, but the situation went out of control. "As AUM shrunk, the fund was left with a higher proportion of less liquid and probably riskier investments. It borrowed money to pay for redemptions but hit the regulatory limit for borrowing," says Prateek Mehta, Co-founder of Scripbox, a mutual fund investment platform. After this, the fund had no choice, but to side-pocket the entire fund.

"If the fund had not been closed, it would have been forced to sell underlying illiquid papers at distress valuations to pay for redemptions. This would have significantly impacted the net asset value (NAV) for existing investors," says Arun Kumar, Head of Research, FundsIndia.com.

There is also a perception that retail investors usually stay away from debt funds and these are mostly favoured by corporates. However, in some of the debt fund categories, including credit risk funds, there is higher-than-average retail participation. "In general, retail participation in debt funds as a category lags their participation in equity funds by a significant margin. It is only recently that retail investors have started looking at debt funds as an alternative to traditional fixed deposits. Given the history of double-digit returns in some of these (credit risk) funds, the share of retail investors in these might be higher than the industry average," says Mehta of Scripbox.

However, corporates are the first ones to sense an impending liquidity crisis and take their money out of risky assets. Since information reaches retail investors late, they often end up on the losing side. "I don't expect majority of companies to be impacted given their strong treasury teams to monitor these risks and their preference for credit quality funds with high AAA ratings and equivalent exposure," says Kumar of FundsIndia.com.

Debt Funds at Risk

When there is a systemic liquidity problem, it spreads from one capital market instrument to another. The problem gets aggravated when fear grips the market. This was evident when unprecedented redemption pressure faced by credit risk funds affected other categories as well.

"Apart from overnight funds, most debt fund categories have seen outflows, especially after the Franklin issue, as investors redeemed investments fearing more such announcements from other AMCs and corporate bond defaults due to the ongoing Covid crisis," says Ankur Choudhary, Co-founder and Chief Investment Officer, Goalwise.com - a mutual fund investment platform.

After credit risk funds, the biggest redemption pressure was seen in medium duration funds. The AUM of medium duration funds category fell 21.50 per cent, from Rs 25,590 crore on April 23 to Rs 20,087 crore on May 20.

"Medium duration funds invest mostly in corporate bonds maturing in three to four years, thereby taking on both credit and duration risks. Retail investors should typically stay away from these funds," says Choudhary of Goalwise.com. Longer duration along with low-quality paper often makes such funds vulnerable to credit as well as interest rate risks.

Another category that witnessed significant redemptions was ultra-short duration funds (AUM declined by Rs 3,379 crore). Three of the closed Franklin funds were from low duration, short duration and ultra-short duration categories. People generally invest in these categories because they hold short maturity securities, which makes them relatively less volatile and risky among debt mutual funds.

"Winding up of six schemes by Franklin Templeton created a panic in among investors, as out of the six schemes, three were investments for shorter periods. This fear is resulting in lower confidence in short duration and ultra-short duration funds," says Gurmeet Singh Chawla, Director, Master Portfolio Services.

The current crisis has challenged the myth that debt funds with exposure to short maturity papers are generally safe. Going forward, investors will need to be cautious while investing even in short-term debt funds.

Apart from these categories, low duration funds also came under redemption pressure, with AUM falling Rs 6.4 per cent, or Rs 5,218 crore, from Rs 81,096 crore on April 23 to Rs 75,878 crore on May 20. "Short-duration funds were also not spared as their AUM fell by Rs 1,267 crore."

Floater funds, which primarily invest in floating rate debt instruments, have also been hit badly. The category witnessed a decline of Rs 100 crore in AUM, from Rs 32,188 crore on April 23 to Rs 32,088 crore on May 20. Due to the floating nature of interest rates, this fund has low risk. However, a good amount of its corpus is often invested in risky debt. Hence, investors looking for safety normally stay away from these funds.

"Low-duration funds carry a benefit of lower interest rate risk. Although such funds hold securities with maturities of not more than one and one-and-a-half years, they may have significant exposure to low-quality debt. A large default can cause erosion of capital. Credit risk in debt mutual funds leaves the investor with two options - continue holding discontinued units or book a loss. Another risk is that these funds actively manage the duration to generate returns, which makes them a bit volatile," says Chawla of Master Portfolio Services. So, in case you have invested in one or more of these funds, review your exposure. If you are a new investor, understand the risk in greater detail before investing.

"Investors need to know that the risk with a debt security is not only due to its time of maturity but credit quality as well, which can be analysed with the help of credit ratings given to it. So, they need to look at the quality of securities in the portfolio of schemes they are going to invest in or are already invested in. If it is difficult to understand these issues, it is advisable to consult a financial expert, who can take them through the health of the portfolio, whether it is debt or equity," adds Chawla.

However, there is a good news of impending recoveries from segregated bad assets of some troubled mutual funds. ABSL Mutual Fund has suspended two debt funds, ABSL Credit Risk Fund and ABSL Medium Term Fund, for new investors. This is intended to stop speculators from entering the scheme and diluting gains of other investors.

RBI's Liquidity Push

Though the central bank's liquidity boost helped cool market sentiment for the time being, any further shock can restart the chain reaction. "With the equity index falling sharply, making lows near 7,500, and foreign institutional investors taking out money in the last two months, market sentiment has turned negative and recovery seems far off. In case of debt market, the continuous sell-off in government securities is forcing investors to ask for a higher coupon rate (as in case of the REC bond issue), making companies withdraw their offerings. All this signals a weak appetite among investors," says Hemant Sood, Managing Director, FINDOC, an online trading company.

It is always easy to find a buyer and sell high-rated debt securities that are considered safe. However, to boost returns, many debt fund schemes invest a part of their corpus in risky debt funds, which are often illiquid. "The problem which remains unaddressed is how to provide liquidity and assurance to the segment below the high-grade category. For this, the RBI and the government have to take steps, including developing a fund or an insurance facility for default on bonds during crises," says Sood of FINDOC.

Need for Regulatory Action

"One noticeable difference is in the liquidity. Equity markets, despite extreme volatility, have seen decent liquidity, compared to high-risk debt instruments," says Aishvarya Dadheech, Fund Manager, Ambit Asset Management. This helps in preventing liquidity woes in the debt market from spreading to equity markets.

Product regulation is another area that regulators should focus on. Many debt instruments can work better if they are held till maturity, while changes at the product level can reduce risks. "Given the illiquid nature of underlying portfolios, credit-risk strategies are better played in a close-ended structure or an open-ended fund with a three-year lock-in similar to ELSS funds. This can ensure that redemption risks are mitigated to a large extent," says Kumar of FundsIndia.com

However, the biggest problem is the breach of regulatory guidelines in terms of exposure to risky assets. Not all funds are allowed to make such high-risk exposure a significant part of their portfolios. But, some schemes have breached the regulatory mandate and invested higher amounts in risky debt products. Regulators need to focus on these. Even in case of the credit risk category, there is scope for tighter rules. "The credit risk category needs to be monitored for the underlying credit quality of the portfolio and risk of continuous redemptions. As the Securities and Exchange Board of India (Sebi) does not mandate a credit quality boundary for other categories (except corporate bond funds category), some asset management companies (AMCs) have funds that follow credit risk-oriented strategies under other categories. This can be found by checking the per cent of AAA & equivalent papers in the underlying portfolios," says Kumar of FundsIndia.com.

What Should Investors Do?

Many retail investors had willingly got into high-yield chasing debt funds without taking into account the inherent risk. Seniors citizens often get lured into investing in these funds with the promise of high returns, and as a replacement to bank fixed deposits. The recent fiasco should serve a lesson for investors to priorities risks before returns. "Considering that high-yield funds are unlikely to meet the risk-tolerance levels of a significant number of senior citizens, they may wish to evaluate an exit from high-yield schemes," says Vishal Dhawan, Founder and CEO, Plan Ahead Wealth Advisors.

One of the best ways to manage liquidity risks is to hold the debt paper till maturity. "Investors should ideally match their investment tenure with the debt fund's modified duration. For investors seeking to create emergency funds, liquid funds are a good bet, while for those looking at long-term investments in debt, a combination of short-duration debt funds with good credit quality, which are well-diversified, are good options," adds Dhawan of Plan Ahead Wealth Advisors. If you have aligned your debt product's maturity with life goals, it could help in managing liquidity risks.

In case you are a new investor planning to bet on debt funds, you should understand the risk first, and then invest in schemes that match your risk appetite. "New investments in debt funds should be carefully selected. Possibly the lowest-tenure debt funds are best suited for first-time investors, especially those who invest in money markets and have a significant high exposure to sovereign-backed securities," says Sousthav Chakrabarty, Co-Founder and CEO of investment advisory firm Capital Quotient.

For those with high risk appetite, "it is important to note that chasing returns in a debt fund is a dangerous game as out-performance usually comes at the cost of high credit risk since a fund manager invests in high yield but low-quality paper to boost returns. From an asset allocation perspective, equity is where retail investors should take risks and the debt part should bein stable and conservative liquid or ultra-short funds," says Mehta of Scripbox.

There are many alternatives that can give you proportionate returns for the high risk that you are willing to take. "Investors who want higher yield and have some risk appetite can explore alternatives such as peer-to-peer lending, venture debt and convertible and non-convertible debentures, but after understanding the issuer and the issuer's business well and checking the impact of Covid-19 on those businesses," says Chakrabarty of Capital Quotient.

Investing in equities such as large-cap funds could also be considered if the investment horizon is five years and above. "Contrary to conventional wisdom of debt instruments protecting capital, investors have lost capital in risky debt instruments lately. This will bring investors to question the sanctity of investing in credit risk funds or other high-risk debt instruments and not in equity, especially since the risk is similar and equities have a higher pay-off," says Dadheech of Ambit Asset Management.

@naveenkumar80