Know The Risks In Debt Mutual Funds

Outlook Money|June 2020

Know The Risks In Debt Mutual Funds
It is better to understand the nature and play safe while investing in these debt instruments
Himali Patel

The turmoil in the debt funds space along with illiquidity issue in the credit markets has affected since the bankruptcy of IL&FS in September 2018. The onset of COVID-19 and the subsequent lockdown impacting the businesses has only added fuel to the fire in the credit market.

Further, in April 2020, Franklin Templeton (FT) Mutual Fund announced winding up of six of its credit-focused debt schemes. This was a rude shock to the entire debt mutual fund investors, who rushed to withdraw their investments from credit funds as well as other debt MF schemes. Although the debt-oriented categories witnessed a net inflow of ₹43,432 crore in April, the credit risk category, given its nature, was one of the worst-hit with a net outflow of ₹19,239 crore during the month. Investors in credit risk funds ran for exits after FT MF incident.

The uncertainty triggered by these events in the debt markets has not only restricted the fund houses’ ability to sell the securities but has made investors question fund houses whether to continue investing in debt funds or not. “When the economy is at the bottom levels and big crisis situations happen, like what we are facing today, the corporate bond markets become very illiquid. The price discovery and the trades happen mostly in OTC market which makes the depth also very poor. If there is a downgrade in any corporate debt paper, the instrument immediately becomes highly illiquid and will find no takers, this makes the life bit difficult,” explains George Heber Joseph, CEO and CIO, ITI MF.

Lower rated papers usually have very low liquidity as they cannot be sold immediately in the market at a fair valuation in India. During times of stress, the liquidity for such lower-rated papers becomes even tighter as everyone becomes risk-averse and wants to lend only to higher-rated corporates. As per the Morningstar note dated April 24, the FT funds were run with a clear focus towards a credit (or accrual) strategy, with significantly higher exposure to AA and A rated instruments as compared to their peers. In such a strategy the idea is to invest in high yielding bonds and stay invested till they mature. This is an appropriate approach to be practiced in such funds or strategies as the underlying securities tend to be less liquid in nature making it difficult to liquidate them in the interim.

Due to this nature of these funds, FT found it difficult to meet the redemption pressure in the recent times. “Credit-risk funds are debt funds that have at least 65 per cent investments in less than AA-rated paper. Credit risk is the risk of default in an underlying debt security that may arise from a borrower failing to make the required payments (principal or interest),” says Deepak Khurana, Performance Director for Fund Ratings and Distribution, Asia Pacific Region at Refinitiv.

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June 2020