How to choose low-risk debt mutual funds?

The thumb rule is that a typical debt fund needs to have an AUM of minimum Rs200cr to keep exposure to one particular paper low.

Nov 22, 2019 09:11 IST India Infoline News Service

Debt Fund
For a long time, most of us believed that debt funds were free of risk. After all, debt was always called the gentleman’s game. Things changed with defaults by large bond issuers like IL&FS, Jet Airways, Essel Group and Dewan Housing among others. The challenge in debt funds is that when a debt instrument is suddenly downgraded to “Default” status by the rating agency, the fund is required to write off 50% of the value of the fund. That resulted in deep damage in the case of several funds with smaller AUM. In fact, debt funds by AMCs like DHFL Pramerica and BOI AXA saw over 50% erosion in their NAV in a short span of time due to their heavy exposure to specific groups. Even larger AMCs like HDFC, Kotak and Birla were forced to postpone their fixed maturity plans (FMPs) in March 2019 due to the failure of the
Essel group to repay the bonds on time.

Not just size, but pedigree can also reduce debt fund risk
Funds like DHFL Pramerica and BOI AXA are cases in point. Due to their small corpus, they were overly exposed to a handful of business groups. That was their biggest risk. That risk is reduced in the case of larger fund houses. For example, when HDFC MF asked for a rollover of the FMP, the AMC was in a position to bankroll and guarantee the returns of investors. That is the advantage you have in large and pedigreed funds. Large funds have also had exposure to some of the troubled groups, but their sheer size cushioned the impact to a large extent. The thumb rule is that a typical debt fund needs to have an AUM of minimum Rs200cr to keep exposure to one particular paper low.

Be wary of long duration funds in a rising interest scenario
The SEBI classification of October 2017 created several fund categories defined in terms of the maturity of papers held by them. However, the issue of credit quality was left largely open ended. Now, maturity length can take care of interest rate risk. This is the risk that bond prices could fall when interest rates rise. Even within this category, there are long duration funds and short duration funds. Long duration funds can be more profitable when rates are falling but can be very risky when rates are rising.

Credit risk is much more rampant than you care to imagine
The big problem faced by mutual funds in the last one year was the credit risk or the default risk. With large debt issuers like IL&FS, DHFL, Jet and Essel Group defaulting, the immediate impact was on the credit risk funds. The credit crisis highlighted the fact that credit risk was an issue even in cases like medium duration funds and short duration funds. In fact, liquid funds also had a significant exposure to CPs of these defaulting companies. To minimize risk, just stick to certain categories where the credit quality is demarcated. For instance, corporate bond funds are mandated to hold 80% of assets in AA+ and above instruments, while banking and PSU debt funds focus on the debt of government-owned companies. If you look at the MF flows for October, the maximum debt fund flows were into corporate bond funds and Banking & PSU funds. Not surprisingly, credit risk funds saw net outflows in October.

Answer is not to avoid debt funds altogether
In India debt funds manage over Rs13,00,000cr and that is more than 50% of the AUM of MF industry. So avoiding debt funds is not an answer because debt funds are here to stay. Unlike equity funds that are riskier and generate returns only in the long run, debt funds can also be effective in the short to medium term. The answer is to be selective and invest in debt funds for regularity, stability and predictability instead of chasing higher returns or alpha. It is estimated that nearly 25% of all debt fund exposures is to NBFCs and you need to be conscious about the quality of bonds held by your debt fund. Of course, the SEBI has intervened and reduced the risk substantially by insisting on 20% mandatory exposure to cash equivalents for liquid funds, 30-day MTM cut-off and a ban on structures and pledge-backed bonds. These measures will certainly help in making debt funds low risk again.

The moral of the story is that you have a choice of managing debt funds at low risk levels. Focus on AUM, pedigree of AMC, interest risk and the default risk. It is as simple as that!

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