Handling downgrades in your Debt Mutual Fund

“Debt Funds are safer and better than FDs” this has been the narrative since last few years. But the narrative has not helped much, at least the numbers say so. Share of retail investors in Debt Mutual Funds is just not encouraging. This is due to frequent accidents that have happened in Debt Funds over last many years. Initially, investors tried their luck with Income and Dynamic Bond Funds only to get caught off guard in rising interest cycles, Fund Managers too didn’t get it right. Later came Accrual Funds a.k.a. Credit Funds, and retail investors once again tried their luck and then downgrades and defaults in bonds in these funds caught them unaware. While today investors are cursing Credit Funds, I would urge not forget that Duration Funds have lost far more investor’s money than Credit Funds.

Debt Funds in all have been a big failure in the asset management industry. The best product among all fancy ones, Fixed Maturity Plans, Ultra Short Term, Low Duration and Liquid Funds haven’t been recommended aggressively and all other categories – Credit Risk Funds, Dynamic Bond Funds and Corporate Bond Funds, that have been pushed have  helped nothing beyond garnering AUM. These funds never focused on investor experience and on top of it were aggressively sold without highlighting the underlying risks in these funds. Read why Credit Risk and Duration Funds have no place in your portfolio

Among the various risks, one of the key risks in debt funds is credit risk which comes from downgrades and defaults which is not many times noticed by the investors. And in last six months downgrade has become a common word not only in Credit Funds but even in Liquid Funds. So here are some important points for investors on how to deal with their investments in such situations. 

Firstly let’s understand what is Credit Risk

Debt Mutual Funds carry 2 kinds of risk – Interest rate risk and credit risk. As you know interest rate risk arise due to changes in interest rates which impact bond prices. Rising interest rate actuates fall in bond price and vice-versa. Credit risk emerges from changes in credit rating of a bond or default by the bond issuer. Credit rating is basically an assessment of the creditworthiness of a borrower. If credit rating of a bond falls then price of the bond also falls. Also if the credit rating of the bond goes below investment grade then a Mutual Fund might start provisioning (reducing its investment value) for its default in the fund by following a conservative approach. Regulation says that if there is an actual default then the fund has to start provisioning for default in phased manner and write-off its investment completely over a period. This actuates drop in the fund NAV and investor starts incurring losses. The key problem in Credit Risk is that a bad investment immediately on news becomes illiquid hence, investors have to act fast in some of these situations.

Following are some situations which warrants investors attention if they are invested in debt funds.

Corporate Governance Issues: If there are news of poor corporate governance and history suggests similar issues with the issuer of the bond in the past, then it is better to avoid such funds. If you are invested and issue pops out, better to exit before the issue aggravates and severely affects the bond prices and thereby the fund’s NAV.

Fall in credit rating: Every day there are multiple credit rating actions happening and getting panicked on every such downgrade is not necessary. Knowing the reason and extent of downgrade is important. AAA rated bond getting downgrade to AA due to some cyclical issues in the industry and temporary cash flow miss-matches can be looked through and investor may stay invested. However, If rating downgrade is steep – AAA to A or AA to BBB, owing to some structural issues like failure in business model, high debt burden, regulatory changes, then it is wise to exit the fund to avoid any further losses.

Drop in Credit rating below BBB: Such fall in credit rating means the bond has gone below investment grade, AMCs may start writing off their investment in phased manner if they follow a conservative approach. In some cases AMCs wait till actual default happens. Important to note is that the moment downgrade happens the yield of such bond rises and it impacts the NAV of the fund. If it is widely expected that the company will ultimately default (this is a difficult call to make but be pessimist than optimist in such cases) then it is prudent to exit the fund before actual default. Better be cautious than sorry.

Concentration: Your action to exit the fund also depends on what is the concentration of the holding that is downgraded. If the holding percentage is below 2% then you may still stay invested. However, one another important point is to see whether other investors are exiting. If other investors are exiting the fund then this 2% holding can become 5% and 10% in no time. As to fulfill redemptions the fund will sell good holdings and what will remain is the bad asset in higher concentration. Hence, if you see that the AUM of the fund is eroding due to such event it is better to exit the fund immediately.

Some basic checks while investing in a Debt Fund to insulate yourself from credit risk

  • Look for Quality. Go for funds that invest in AAA and AA rated bonds only and avoid funds that invest in A rated bonds. One easy way to identify the quality of portfolio is by comparing portfolio YTMs (Yield till maturity) with similar category of funds and question higher portfolio yield. If a fund with similar credit quality has a higher YTM by over 1%+ then it is a sure sign that Fund Manager is taking some aggressive credit calls. Stay away from such funds.
  • Avoid Concentration. Stay away from funds that have concentrated exposure to few issuers even if they are rated AAA or AA. Remember IL&FS was a AAA rated bond and it still defaulted. The only way to limit losses in such unexpected event is to have lower concentration.
  • Lower the maturity of the bond higher is the stability in its rating. Taking call on the companies solvency for 1 or 2 years is fairly easy than forecasting it for 3 to 5 years. Hence, even if you want to invest in Credit Risk Funds look for a portfolio that has lower maturing A and AA rated bonds.

So next time you invest in Debt Funds do keep these points in mind and have a happy investing experience. Remember debt funds are for safety and not for shoring up your portfolio returns, leave that job to equity funds.

Happy Investing!

 

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2 thoughts on “Handling downgrades in your Debt Mutual Fund

  1. They are not safer – but I would argue they are better than FDs. What you need is better understanding of risk management – as few tenets you have highlighted. Surely there will be periods like last 6 months, where returns will be weak. But if default rates are anything to go by, these will be few and far btw – and 70-80pc of time returns superior to FDs. In fact, like for like yields have gone up only because of ilfs – else investors were not being paid enough spread to compensate for credit risk.
    https://determinedinvest.wordpress.com/2019/02/08/understanding-risk-management/

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