Know the risks in debt funds before parking your savings

Debt funds are facing a risk re-rating by investors in the light of the covid-19 pandemic and the unprecedented move by Franklin Templeton Mutual Fund to shut six of its debt fund schemes. If you have been singed by the events or are apprehensive about the economy and the impact on debt fund investments, then this is the time to revisit the reasons why you have invested in debt funds.

“Debt funds are not seen from an asset allocation perspective. The selection seems to, typically, start with which category—credit or duration—is expected to do well and that indicates that the investor is chasing returns. People get whipsawed by short-term market movements, panic and then they redeem. But for an investor who has made an allocation-based investment, these short-term yield changes should not matter,” said Rajeev Radhakrishnan, head, fixed income, SBI Mutual Fund.

Investors must be realistic with the risk they are taking with the “safe portion” of their portfolios and match it to the risks inherent in debt funds for a good fit. To do this effectively, it is important to understand the risks.

the Risks

The IL&FS saga in 2018 set off a series of credit events that have brought grief to debt fund investors. With economic activity being affected by the covid-19 pandemic, the continuing risk of greater stress on the companies’ ability to meet their repayment obligations is real. The credit ratio of Crisil, which measures upgrades to downgrades in the credit ratings assigned, slid to 0.77 for the second half of FY20 compared with 1.21 times for the first half, clearly indicating intensified credit stress in the economy. “As a thumb rule, lower-rated credits need positive growth momentum and lower cost of money to turn good. As only one of the two aspects are at play, we expect lower-rated credits to remain less reward-risk-favourable,” said Saurabh Bhatia, head, fixed income, DSP Investment Managers.

As the pick-up in economic growth is some quarters away, investors should focus on the quality of debt fund portfolios and how the credit risks are managed in terms of rating profile, parentage, extent of exposure and so on. “The quality of the underlying portfolio matters. If your approach to credit has been conservative and underlying due diligence has been good, there is no need to worry,” said Radhakrishnan.

The other risk that debt fund investors contend with is that of interest rate risk or the fall in the value of the portfolio as interest rates go up. A high fiscal deficit as governments deal with falling revenues, increasing expenditures to tackle the covid-19 crisis and supply-shock-led inflation stoke fears of rising interest rates in the economy. But the experts don’t see that as a possibility. “Yields are headed down across the curve because of liquidity and the rate stance. In a weaker economy where growth is the biggest concern and taking a significant back shift, demand inflation is not a concern at all. Policy framework will, therefore, be focused on reviving growth. In such a situation, you can’t have interest rates even where they are today,” said Radhakrishnan.

“Risk to the reversal of interest rate cycle will emanate from a substantial fiscal package that is not supported by the central bank-led bond buying. This is not our base case,” said Bhatia. If the Reserve Bank of India (RBI) does not intervene to make higher government borrowing non-disruptive, it will push up the cost of borrowing for the private sector, which is inconsistent with the needs of an economy potentially facing recession.

The shutting down of six debt schemes by Franklin made investors fearful of similar gating by other funds. Industry and market experts agree that the schemes’ portfolio concerns were exacerbated by poor secondary market liquidity in lower-rated bonds. With RBI stepping in to provide liquidity to the bond markets and to mutual funds directly, the fear of a contagion receded. “Funds have done well to honour redemption for the most part despite the stressed environment with liquidity getting constrained, trading hours being curtailed and other dislocations,” said Radhakrishnan.

However, the issues are real and unless the risk aversion of lenders corrects, lower-rated papers will remain at elevated levels of risk from illiquidity. “Corporate bonds have benefited with TLTRO and surplus liquidity. That said, the main beneficiary of these measures have been prime rated corporate and PSU entities as RBI has (so far) provided banks liquidity and not capital to buy bonds,” said Bhatia. “While there is enhanced risk aversion, entities with strong balance sheets and credible management that inspire the confidence that they will be able to manage short-term disruptions are able to access market funding,” added Radhakrishnan, underscoring the importance of selecting funds with a clean and good quality portfolio.

What you should do

Debt funds make a case for themselves on account of their ability to provide better post-tax returns combined with better liquidity features compared with traditional fixed-income products. However, investors have to factor in the higher credit risk environment. Staying with a portfolio that invests in government securities, quasi-government securities such as PSU bonds, bank issuances and highly rated private sector companies of good parentage give the comfort of quality. A portfolio with high-quality papers is also easily liquidated when the need arises.

The risk of volatility from interest rate changes can be best managed by having a minimum holding period for each debt fund and ensuring that the duration of the fund is not more than the investor’s own minimum holding period. Investors looking to invest for their core allocation should consider open-ended funds keeping the tenor of their goals in mind. “If you do not want to take any material rate risk or credit risk, which in today’s atmosphere will be the first preference, short-term fund is the best option. It has one to three years’ maturity, which is a moderate interest rate risk and most short-duration funds hold high quality G-secs plus PSU or PFI AAA or large corporate AAA papers,” said Radhakrishnan.

For investors looking for the comfort of predictability of returns and low volatility, like a fixed deposit, debt funds that follow a target maturity strategy such as the Bharat Bond ETF, open-ended funds such as the DSP Corporate Bond fund and Axis Dynamic fund are suitable. These funds structure their investment portfolios in such a way that they are able to give investors visibility on the yield despite being open-ended, provided investors remain in the funds till the targeted maturity period. They do this by investing at any point in time only in debt instruments whose tenor match that of the residual tenor of the portfolio. They combine the benefits of a fixed maturity plan with liquidity and greater transparency of an open-ended fund.

The risks in debt funds are manageable provided there is a well-thought process of determining the investment need, evaluation, selection and monitoring. It is not a product that you can invest and then forget about till maturity.