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Business News/ Money / Personal Finance/  Does your debt strategy need to be reorganized?

Does your debt strategy need to be reorganized?

Evaluating debt funds has become more difficult as defaults and downgrades abound
  • According to planners, buying debt funds is better than investing in a company’s papers directly
  • Most planners have moved clients’ money out of credit risk funds or reduced allocation to the category (Photo: iStock)Premium
    Most planners have moved clients’ money out of credit risk funds or reduced allocation to the category (Photo: iStock)

    Earlier this month, when credit rating agencies revised the ratings of Bank of Baroda and Vedanta downwards, Suresh Sadagopan, founder of Ladder7 Financial Advisories, a Sebi-registered adviser, swung into action to check if any of his clients’ debt funds had a significant exposure (2% or more) to the papers of these companies.

    Since the beginning of 2019, Sadagopan has started proactively reviewing debt funds on the basis of negative news breaks and downgrades of companies they may be exposed to. Earlier, he relied entirely on the pedigree of the fund houses and the experience of the debt fund managers. “Most defaults didn’t happen overnight. For many of these companies, there was news of deteriorating financials or mismanagement for some time," said Sadagopan.

    Though evaluating debt funds has become tougher now, financial planners still prefer them over other debt instruments, even if it means keeping a close watch on them. “Earlier, defaults were one-off events. They are more common now. Debt funds are now a difficult asset class," said Malhar Majumder, a Kolkata-based financial planner and partner, Positive Vibes Consulting and Advisory. To reduce the risk, given the rising credit defaults, planners are now adopting different strategies. We tell you what these strategies are and how you can implement them..

    Rising defaults

    The size of defaults and the number of companies defaulting are on the rise. In the previous financial year (FY), 2018-19, the Infrastructure Leasing & Financial Services Limited (IL&FS) default was the biggest and most shocking event for debt funds. Many other prominent companies such as DHFL and Yes Bank joined the list in FY20.

    Around 164 debt schemes were affected after Dewan Housing Finance Corporation (DHFL) defaulted in FY20. The total exposure these schemes had was about 4,276 crore, according to data from the rating agency Crisil. Yes Bank affected about 29 schemes, which had an exposure of 2,605 crore. Most of the exposure was to AT1 bonds.

    The default in Reliance Home Finance Pvt. Ltd impacted around 36 debt schemes with an exposure of approximately 1,872 crore to its papers. Around 30 debt schemes have papers of Vodafone to the tune of 592 crore, which has witnessed significant downgrades.

    Financial planners point out that many of the problems in the debt market started when IL&FL defaulted. It was a significant entity backed by well-known institutions such as the Life Insurance Corporation of India and the State Bank of India and had the highest credit rating. “The IL&FS default has caused a systematic problem. It has disrupted the debt market, and lenders are not able to trust the borrowers. The domino effect is likely to continue" said Sadagopan.

    Different strategies

    There are no tax-efficient alternatives to debt funds if you are in the tax bracket of 20% or above, and stay invested for three years or more. According to financial planners, buying debt funds is better than investing in a company’s papers directly. “Debt funds invest in multiple papers. If one company defaults, only a part of the portfolio would be affected. Compare to buying non-convertible debentures of DHFL. The investor would have to write-off the entire investment," said Steven Fernandes, Sebi-registered investment adviser and founder of Mumbai-based Proficient Financial Planners. Planners are sticking to debt funds, but have changed how they in invest them.

    Low exposure to credit risk: Most financial planners have moved clients’ money out of credit risk funds or maintained low allocation to the category. “For almost 98% of the clients, we have exited credit risk funds and moved to other categories," said Majumder.

    High diversification: Majumder has also started distributing his clients’ money into more debt instruments than he did before. Earlier, if he had 100 to invest in debt funds, he would allocate 40 to credit risk funds, 40 to corporate bond funds, and split the remaining money between low-duration and liquid schemes. Now, he would continue to invest 40 in corporate bond funds, and for the remaining 60, he looks at gold funds, banking and PSU schemes and medium-term bond funds, besides investing in liquid funds.

    Using arbitrage funds: If you want to invest money for over one year but less than three years, financial planners suggest opting for arbitrage funds. They are more tax-efficient than debt funds for those in the tax bracket of 20% or higher. “Arbitrage funds invest in equity derivatives. They earn their returns on the mispricing of equity shares in the spot and futures market. Their returns are similar to debt funds. As they invest over 65% in equities derivates, they are taxed like an equity fund. If withdrawn after one year, gains over 1 lakh are taxed at 10%," said Fernandes. Arbitrage funds use equity futures and options and hedge all their positions, so change in stock prices don’t impact their returns.

    Keeping a tab: Due to the recent defaults, planners are looking at debt portfolios more closely than they did before. “What has changed for us recently is the way we analyzed a debt fund. Earlier, we would look at the top 70-80% of a debt fund’s holding. Now, we go deeper. We look at each holding of the debt fund and regularly monitor how the allocation is changing," said Fernandes.

    Understanding nuances: After the Yes Bank default, many investors realized that perpetual bonds (AT1) are different than regular bonds. Financial planners are now looking at similar nuances. Take the example of state development loans, which are considered as safe papers that the central government issues. Some planners are revisiting the possible scenario of a state’s finances deteriorating.

    Sticking to shorter duration: Apart from two categories–corporate bond and banking and PSU debt funds–most planners are sticking to liquid, ultra-short duration and short-duration funds. They are opting for shorter duration funds with a low mark-to-market portfolio.

    Open to other options: Unsure of defaults and rating downgrades, planners have also stopped convincing clients to stay put. Many of them are explaining the present situation, the options available and asking them to decide on the course of action. Many clients who are in their 50s or above are opting for traditional debt products with guaranteed returns, according to planners.

    Mint’s take

    Though debt funds are well-regulated, defaults have happened and more may follow. Fund managers can’t control the rating downgrades and defaults of individual companies, but they can avoid higher exposure to a single group and do their due diligence before investing.

    You can take a cue from the strategies being adopted by financial planners. If you think it’s difficult to track your funds closely, work with a planner. “Even in a debt portfolio, one needs to diversify. There must be allocation to debt funds, fixed deposits of different banks and small savings schemes. Don’t rely on only one product category," said Deepesh Raghaw, a Sebi-registered investment adviser.

    Those who are uncomfortable with debt funds can look at post office FDs, which are still giving better returns and bank FDs. The interest rate of post office FDs ranges between 6.9% and 7.7% for one- to five-year tenures. Rates from small savings schemes are even higher. For example, Sukanya Samriddhi Yojana currently offers 8.4%, and Senior Citizen Savings Scheme gives 8.6%. If you want to park your money for a few days or weeks, opt for overnight funds.

    It’s a good idea to spread your debt investments across different categories and instruments.

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    Published: 18 Mar 2020, 11:14 PM IST
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