Defaults left debt investors in the lurch in 2018

However, the real hurdle came in the second half of 2018 with default in interest payments and subsequent downgrade of debt securities from IL&FS Group companies. This marked a landmark shift in perception given that, till then, IL&FS was an AAA-rated debt security and one assumed it to be at the highest level of safety as far as payments were concerned. Overall, as earnings failed to recover meaningfully, across the board, credit risk funds saw a fall in returns.

Within days, select securities issued by IL&FS Group companies were downgraded from the highest rating to default rating. This quick, unforeseen change left mutual fund schemes which had exposure to these securities contending with losses. Now it would be acceptable if all the losses came through in high-risk debt funds. However, as it happened several investors in short-term income funds and ultra short-term funds also got caught at the wrong end and saw their scheme net asset value dip. 

The interim losses in these short-term funds were not easy to bear and, as a result, redemption, especially from large-ticket corporate and institutional investors started coming through almost immediately. To fund these losses, asset managers needed to sell other securities.

The perception around non-banking finance companyies’ abilities to generate short-term funds to fulfil repayments began to be questioned and soon there was a systemic panic which led away lenders from this segment. Yields shot up and all this put together resulted in volatile returns from debt funds.

According to Khyati Mashru, founder and chief financial coach, Plantrich Consultancy LLP, “While there is a lot of awareness around equity, for debt investments people are not as aware. We have to communicate proactively on how the return from such funds is made. Debt funds deliver superior returns as compared to fixed deposits but that comes with some risk—many clients don’t understand this." 

In 2018, debt funds as a category saw negative net inflows to the tune of ₹ 1.63 trillion, out of which ₹ 0.70 trillion went out in September and October 2018, the two months most affected by the NBFC crisis. 

Nobody wants to be saddled with bad assets. For MF investors, access to liquidity means that if an ILFS kind of event happens, they can exit just as quickly even if it is at a loss. But the scheme itself has to look for buyers in other securities to generate liquidity for further redemptions. Moreover, fresh investments are hard to come by in such times.

Given the illiquidity in debt markets, what follows is a vicious circle where the scheme returns suffer unduly. To avoid this kind of a situation and recognising the binary nature of debt investing, Sebi has since allowed (on 12 December 2018) mutual funds to create side pockets to separate out bad assets. 

According to R. Sivakumar, head fixed income, Axis Asset Management Security Ltd, “When there is a credit event, it is hard to accurately mark to market the defaulting security. While funds do mark down the value of securities that are downgraded, investors can suffer more if the value recovered is lower than the marked down value." 

Side pockets help in preserving the good portfolio as it is so that the need for distress redemptions can be minimised. The bad security is moved to another pocket which is closed-end in structure and the daily value for that is managed separately. If the fund can recover the money, those investors who were affected can recover dues justly.

Sebi is yet to furnish the details of how this will work. One hopes that while it will address the problem adequately, asset managers will also exercise due restraint in using this facility. 

As inflation touches the lowest levels in many months, there is once again talk of interest rates being cut.

This might be the silver lining that debt mutual fund investors are looking to start 2019 with.