IL&FS crisis: How real is the risk in debt funds?
Stay invested even if your debt funds are hit by IL&FS downgrades until we know its turnaround plan. Any recovery of past dues will shore up NAVs
Debt fund investors have been in a tizzy this past month over the downgrades in credit ratings of Infrastructure Leasing & Financial Services Ltd (IL&FS) and some of its subsidiaries. A total of about 33 funds (across liquid, ultra short-term bond funds, short-term bond funds, credit risk funds, etc.) had these companies in their portfolios; the cumulative value of these holdings in these funds added up to ₹2,308 crore as on August-end 2018, according to data from Crisil Ltd. At least three fund houses had to mark down some of their schemes’ portfolios by about 25% to 100% of the value of the underlying securities as IL&FS and some of its companies either saw a sharp fall in their credit rating or didn’t return the principal.
The short-term scrip of Infrastructure Leasing & Financial Services Ltd saw its credit rating fall to a rating of D on 17 September 2018 (indicating default), down from a rating of A4 (as on 8 September) and A1+ (as on 6 August). Similarly, IL&FS Financial Services Ltd’s short-term paper’s credit rating fell to ‘D’ on 17 September, down from A4 (as on 8 September) and A1+ (19 February 2018).
According to the mutual fund industry valuation norms, rating agencies Crisil and ICRA provide scrip prices daily to all funds across all securities that funds have invested in. But when a security turns below investment grade (BBB-rating), fund houses value securities as per their internal valuation norms. This time, as per the industry’s consensus, fund houses marked down the security’s value by 25% when the scrips rating went below investment grade rating (BBB-rating). The net asset values (NAVs) went down to that extent. Later, when some scrips defaulted, some funds wrote down the entire value of their holding, while a few other funds wrote down about 50%. If you are an investor in such schemes, should you withdraw?
No mutual fund is risk-free
Contrary to popular belief, debt funds are not risk-free. Though they are less risky than equity funds, debt funds too come with two kinds of risk—interest rate volatility and credit risk. The former happens when interest rates move—specifically upwards—that causes a debt fund’s NAV to move. The latter happens when an underlying instrument’s credit rating drops or defaults on interest and principal repayments.
Joydeep Sen, founder, wiseinvestor.in, said investors haven’t yet understood the risks in debt funds. “Historically, there have been instances where if a problem occurs with any underlying security in a debt fund, either the asset management or the sponsor company bought the said troubled paper from the debt fund and paid the money back to the MF scheme. But in the last few years, this has not happened. Whether it is JP Morgan India Asset Management (Amtek Auto Ltd), Taurus Asset Management Co. Ltd (Ballarpur Industries), or in the present IL&FS case, fund houses did not take the hit on their own books. They let the scheme take the losses and that is why the NAVs in all these cases fell,” said Sen.
How to manage risk?
Although debt funds are beneficial, managing risks is tricky. A senior analyst at a foreign brokerage house said that if you do not like taking too much risk, keep your investments in credit risk funds (that invest in low-rated papers) to a minimum and invest a majority of your investments in schemes that focus on high-rated bonds (corporate bond funds). Thanks to the recent classification exercise that the ₹23 trillion mutual funds industry undertook at the behest of capital market regulator Securities and Exchange Board of India (Sebi), both these type of funds, credit risk and corporate bond funds, are now clearly segregated, and come with clear boundaries.
The problem comes when other types of debt funds, like liquid and ultra short-term bond funds, take risks that not everyone is comfortable with. Take IL&FS and its subsidiaries’ example. It’s not just the credit risk funds that invested in these scrips. Apart from credit risk funds that were invested in IL&FS Transportation Networks Ltd, ₹12.52 crore worth of medium duration funds and ₹62.58 crore worth of ultra short-term funds were also invested in them, according to figures given by Value Research. Liquid funds worth ₹406.19 crore had invested in IL&FS Financial Services Ltd, whose short-term paper defaulted and ₹49.84 worth of liquid funds have invested in Infrastructure & Leasing Financial Services Ltd.
If liquid and ultra short-term bond funds are meant to be the least risky of all debt funds, then what should you do if your fund is caught holding such companies that get into trouble? The analyst quoted above reiterates that it’s important that investors sit with their financial planners and stick to funds that invest in the highest grade paper and also with those funds that come with a proven track record. That can minimise risk. Although investment grade papers too can quickly turn into junk, although the chances are lower (see graph), just like it happened with many IL&FS papers that funds have held.
Further, there were a few fixed maturity plans (FMPs) that also invested in IL&FS papers. These are closed-end funds that come with a fixed maturity; those who wish to exit prematurely can do so on stock exchanges at market prices (these usually trade at prices lower than the prevailing NAVs) provided there are enough buyers there. Says Maneesh Dangi, co-chief investment officer, Aditya Birla Sun Life Asset Management Co. Ltd: “A closed-end fund like an FMP gets only 2-5 days to deploy its entire corpus. In such a short span of time, the fund manager may not find a whole wide bunch of securities to invest the fund’s proceeds in. Therefore, FMPs have concentrated portfolios. One such company’s default in a concentrated portfolio can bring down the NAV by a fairly large margin.”
As per Crisil and Value Research, nine FMPs worth a total corpus of ₹1,938 crore have been adversely affected by their investments in various IL&FS companies. They had invested 3-10% each in such companies. Industry experts said here too, investors can sit with their advisors to understand what sort of portfolios FMPs will invest in, before they invest in them. Stick to those that will invest in high-rated instruments. But if you don’t mind taking on some risks, there are FMPs that will take on credit risks as well.
Should you withdraw?
If you have invested in a debt fund that has got affected by IL&FS defaults, should you withdraw? “No,” said Sen. “There’s not much that investors in these affected debt funds can do, now that the NAVs have already fallen post default and downgrades.” Sen said that if a solution is worked out at IL&FS and the companies pay their lenders (mutual funds and insurance companies), then the payment will push up the NAVs of those funds that had to mark them down earlier. “Exiting immediately means booking the loss, rather remaining invested will help recoup through accruals over time,” said Amandeep Chopra, head fixed income, UTI Asset Management Company Limited.
If you are invested in affected FMPs, it’s always better to stay invested till maturity. But even in open-ended funds, it makes sense to stay invested in these funds as IL&FS itself is busy working out a solution.
Lisa Pallavi Barbora contributed to the story
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