BackAre debt mutual funds becoming riskier?
Schemes are adding high yield bonds. Understand nuances before concluding such funds are equally risky
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Investors in fixed-income funds have seen returns swell up. Indeed opportunities to gain in this market have increased over the last 18 months or so once the possibility of rate cuts combined with the advent of a new government more or less became a reality and aided sentiment.
The average returns for ultra short-term funds, short-term income funds and income funds have been around 9.00-9.5% over the past one year.
In the last six-odd months, however, bond market yields have remained more or less flat and subsequently fund managers have lowered the high duration positions that many funds carried. The attention has now decisively shifted to premium on high yield securities, credit and income opportunity funds. These are funds that invest in debt securities of less than AAA credit rating to take advantage of the higher yields.
“In a high interest rate environment, a fund which offers 1.5-2.0% more may not seem exciting, but when overall yields are falling, this is desirable," said Nishant Agarwal, head products and family office advisory, ASK Wealth Advisors Pvt. Ltd.
On the basis of May 2015 portfolios, such high yield securities contributed 27.1% to portfolios, which is 21.3% higher from a year ago. In fact, many short- and medium-term income funds, too, have added a higher proportion of such securities compared with a year ago.
However, high returns come with high risks; in this case it is notably the liquidity and default risk associated with such securities. But do these risks matter as long as the fund is delivering consistent returns?
It matters if your expectation from the fund differs from the strategy it adopts. However, before jumping to the conclusion that all funds with high yield bonds are risky and have to be sold, you should understand the nuances of the portfolio and fund strategy.
Mint Money helps you understand such funds better.
Understanding the fund’s strategy
The question remains, should you worry if your fixed-income fund has a high exposure to low-rated securities? You should, if the increase in exposure is sporadic and inconsistent with the investment objective of your scheme and the capability of the fund house to manage such schemes.
“In 2009-10, there were hardly any credit funds but now there are many. The market is chasing this segment for incremental returns, but, changing the strategy also means adding risk," said G. Ramesh, principal-client partner, Entrust Family Office Investment Advisors Pvt. Ltd.
If you find that the monthly portfolio of a scheme over the past 6-12 months varies irregularly in terms of the rating profile of securities, then it may be an indication of the fund following a trend rather than adopting a defined strategy. This makes the investment objective of the scheme unclear and in turn could lead to a mis-match in terms of investors’ return expectations.
Watch the historical performance; fund management capability is best reflected in consistency of performance. “
“Consistency is most important. I wouldn’t second guess the fund manager on the choice of securities unless returns start to get volatile," said Karthik Jhaveri, founder and director, Transcend Consulting India, a wealth planning firm.
If the scheme has a mandate to hold high yield corporate bonds to maximize accrual income and give a premium over the short term funds, then you will find that its portfolio historically shows a high proportion of bonds, which are below AAA-rated. This means taking exposure to such securities is built into the investment objective of the scheme from the very beginning. While some fund managers prefer to buy and hold securities to generate consistent accrual income, there are different strategies that get followed.
“Primarily there are three reasons for us to buy securities in this space—attractive valuations which we are able to spot before the market, the credit rating might be poised for an upgrade which, again, we are able to identify before others, and there are first-time issuers with strong balance sheets," said Sujoy Das, head-fixed income, Religare Invesco Asset Management Co. Pvt. Ltd.
As bank credit remains expensive, many companies are accessing the bond market for funding and this has given a boost to the supply. The fund’s investment objective along with the fund house’s capability to analyse and identify high quality securities is critical in your decision to take exposure to relatively lower rated corporate bonds through debt funds. Remember, a low-rated company could also be fundamentally sound.
“Along with a thorough credit analysis of the issuer, other factors such as security collateral, and presence of a guarantee, could help enhance the credit profile of the bond," said R. Sivakumar, head–fixed income, Axis Asset Management Co. Ltd.
Minding the risks
Then come the risks. The first point of concern is the liquidity risk. Simply put, how difficult is it for the fund to find a buyer when it wants to sell a security. After all, this is by and large an over-the-counter market with issuers negotiating fund raising. AAA-rated bonds still mop up most of the liquidity in the bond market.
“When it comes to bonds rated below AA, we need to take into account illiquidity risk as these bonds are not actively traded in the secondary market. One way to mitigate liquidity risk is to invest in short-term debt in case of lower rated issuers. It is also important while investing in lower rated companies to ensure adequate diversification of the portfolio. This reduces the impact of downgrades or defaults on the total portfolio," said Sivakumar.
Das, however, is not too concerned. He says that while there is a risk at present, there are enough buyers in the market.
Ideally, if the economy improves and the expectation of lower interest rates expands, exiting bonds from good quality companies will not be difficult as you can find buyers in the secondary market. However, the economic situation isn’t clear yet. And the illiquid market can lead to a valuation mismatch. “If there is a significant liquidity crunch that leads to forced selling thanks to redemption pressure, there could be issues with valuation and mis-pricing. And, finding a buyer itself may not materialize," said Ramesh.
Another way to lower risk is to stick with schemes with large assets under management (AUM).
“A large fund typically can manage a sudden redemption through daily cash flows and existing assets. Having sufficient exit loads can also dissuade investors from fleeing too early," said Agarwal.
The other concern is the risk of default. The Securities and Exchange Board of India’s regulations allow mutual funds to invest only in investment-grade debt (up to BBB rating), which have a relatively high degree of safety for paying financial obligations. Hence, experts aren’t too concerned about default risk.
If the company is fundamentally sound and cash flows aren’t impaired, default risk is at bay. Once again the ability of a fund manager to identify quality companies comes into play, and in a sense, any mismatch in this is the real risk.
“Large-sized funds are in a better position to negotiate structured deals that are secure. Fund managers should be able to invest not only based on the credit rating but also be able to judge the credibility of the promoter group in cases where rating is low," said Agarwal.
Mint Money take
As bond yields inched up in the past few months and duration strategy became less attractive, credit opportunity funds found more takers and have built a niche for themselves.
Moreover, these funds have found favour with some investors who were earlier invested in one-year fixed maturity plans and have now moved their investment horizon forward to at least three years given the change in taxation norms.
However, investors may not realize, but short duration funds that are generally considered to be low-risk, have also increased exposure to lower rated securities.
Clearly, if safety and liquidity is what you are after, stay away from funds with high or increasing exposure to relatively lower rated securities. The risks are relatively higher and this can lead to daily volatility in net asset value (NAV), which you may not be comfortable with.
However, if you are looking for that extra return and are willing to accept the slightly more complex risks involved, these funds will work for you. Even then, portfolio liquidity and default risk need to be assessed in the context of the rating profile of securities along with the credibility of the fund managers to identify good quality companies. A well-diversified portfolio is critical for retail investors.
Lastly, you must analyse the consistency of performance that the underlying fund has displayed. And if it is a new fund, you should go back to assessing the investment team’s credibility in the area of identifying quality corporate bonds.
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