(This is from today’s Deccan Chronicle)

The Credit Risk in Debt Funds

 

All debt fund investments have two kinds of risk- Credit Risk and Interest Rate Risk. Once we understand this, we are better equipped to handle bad news.

 

We invest in ‘debt’ funds with the basic premise that our principal is protected. Those of us who used to invest in Fixed Deposits of companies have found this to be a superior alternative, on the understanding that we do not risk losing all our money. In a traditiona l FD, we have seen delays, defaults in interest and principal amounts. The list of companies where people have lost money, is endless.

 

A Debt Mutual fund (liquid, income, Fixed Maturity Plans and the likes thereof) invest in a diversified range of companies so that one default does not impair the entire principal. However, they have one big difference, as opposed to the traditional fixed deposit. In a FD, we are not bothered by movement in interest rates. We know that we will get a precise amount on maturity. Companies do offer a ‘premature’ withdrawal option, with some penalites on the interest component, for such a withdrawal. Legally, they are not obliged to repay before the due date. This is where the Mutual Fund scores. We can withdraw our money at will (redemption period could be a few working days).

 

The one big distinction between Debt Funds and FD is the valuation. Every day, the NAV changes. Accrued income is added on a daily basis and changes in interest rate impact the principal value. When interest rates fall, the NAV rises and vice versa. However, the changes in our economy are not so drastic that they impact your principal significantly.

 

This is where I have a grouse with MFs. As a retail investor we think that interest rate movements are beyond control, but credit quality is paramount. We do not like it when a MF suffers an erosion in NAV because they hold a paper that got downgraded or defaulted. MF managers are in a rat race, where their daily growth in NAV is compared. This pressure forces them to go for papers with higher risk and return.

 

The retail investor, in effect, assumes that every paper is high quality. In a sense, the MFs have to tailor make something for the retail investor, where they clearly say that the fund can invest in below high quality paper. I would think that high quality would denote at least a Double A rating from two or more credit rating agencies. This would minimise the risk of default, but not of downgrade. The rules are such that when there is a downgrade, the market value of the investment has to be correspondingly notched down. This creates an anomaly. For example, if a debt is downgraded from AA to A, it still does not mean that the money is lost. It just means that it will be ‘marked down’, by say around one percent. So, when the downgrade happens, the NAV is reduced. However, when the paper matures, the Fund House will still realise the exact amount. Which wold give a kicker to the NAV on redemption! So, those who withdrew their money before the maturity would lose some fraction of their money!

There is no solution to this. MFs are continually buying and selling securities, based on market contions, inflows and outflows in to the fund. So if there is a credit downgrade or upgrade, there is bound to be some changes on the NAV. As an investor, we have to be aware of this risk, that is always present. We have to trust that the fund house will be managed well enough to keep the risk as low as possible, by ensuring investments only in to High Quality paper.

 

Yes, the law does not probibit them from investing in less than High Quality paper. However, the lay investor is not given a choice in this.

 

So, my suggestion is that MFs can divide the option for retail in to saying that he can choose a scheme that invests only in Triple A paper or one that invests in minimum AA paper or even a scheme that invests a portion of the money in Single A paper. SEBI can help by prescribing minimum investment sizes for different risks. A big disclosure would help. The riskier segments can have a high entry threshold. Say a scheme that would invest in Single A paper, could prescribe a minimum ticket size of Rs.25 lakh. The presumption is that richer the person, the better the understanding of risk, generally. And advisors can also have a code of conduct by having an alignment between investor investment in MF and the appropriate risk tolerance

 

Investors have to take the effort to educate themselves. And advisors have a big role to play in this. They can guide the investors based on their profile.

 

 

 

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4 thoughts on “Of Bond Funds, Income Funds and Credit Risk

  1. Sir, aren’t liquid funds better off in returns of risks and returns – since its very short term, so credit risk is minimal (companies focus on repaying short term paper first, in general) and interest risk too..

    The returns are certainly not too different compared to other debt funds (based on value research data) in the longer run (5-10 year period etc.). Please share your thoughts.

    Like

  2. It is baffling . . .

    1) Debt investments are primarily for safety of principal & periodic income. But, higher returns are sought by compromising on this very safety aspect.

    2) The timely repayment of debt obligation comes from the impending earning power of the business, or from the ability to raise more capital (Debt or Equity). It beats logic, that there seems to be no problem in lending to such businesses which one is uncomfortable owning, even fractionally.

    Liked by 1 person

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