Debt fund managers are finding it difficult to beat the high inflation in India for the past 2 years. While all categories of debt funds ultra short term, short term and income funds were able to beat the inflation rate in 2011, returns from these products have lagged behind inflation in 2012 and 2013.

With the RBI governor, Raghuram Rajan focused on targeting inflation, a scenario of declining interest and hence the possibility of an aggressive duration call in debt looks some time away. In such an environment, one of the ways to enhance the returns of a debt fund is to increase exposure to papers which are rated lower than AAA. These papers give a yield pickup of 1-3% depending on the quality of the paper over and above the AAA yield.

The initial success of a few asset management companies to deliver superior returns by taking higher credit risk has also led to competitive pressure in this industry, resulting in fund managers either increasing the exposure in lower rated papers in their existing funds or to launch Income Opportunity kind of products which specifically invest in lower rated debt.

For short term funds, the exposure to papers which are rated less than AAA (or equivalent) has moved up steadily from 28% to 42% of the portfolio over the past 3 years. For the ultra short term category, exposure to papers which are rated lower than AAA (or equivalent) has moved up from 3% to 16% of the portfolio.

This exposure to these papers can take various shapes in the form of lower rated Non-Banking Financial Companies or Manufacturing Companies to unrated papers of Real Estate Companies or lending Againstsecurities types of transactions.This increases the risk in the portfolios in 2 ways. These papers carry higher risk of default than the safer AAA debt. Secondly, the papers typically tend to have lower liquidity as compared to G Secs or AAA rated papers. This could become a concern in case of redemption pressure on funds, as was seen in 2008.

This is not to say, that exposure to lower rated debt is outright bad. This can help to enhance the returns on the portfolio, especially in an improving economic environment, when some of these papers could be upgraded. But I think that it is important for the investors to have a look at the portfolios or talk to your financial advisors and be cognizant of the risk which they are getting into prior to investing. This can save a lot of heart burn later

Niranjan Risbood, Director Fund Research, Morningstar India