(Photo: iStock)
(Photo: iStock)

Don’t shun debt funds but choose carefully

  • Debt funds beat FDs in terms of post-tax returns, but look at fund size and category
  • Investors looking to minimize risk should move to overnight funds. They can choose these instead of liquid funds for STPs into equity funds

Last week, the unthinkable happened for debt fund investors. Most of the 165 mutual fund schemes across 24 asset management companies (AMCs) that were exposed to debt issued by DHFL group as of 30 April had to write down the value of their holdings by 75%. As a result, the value of several of these schemes fell sharply, with one of them, DHFL Pramerica Medium Term Fund, falling by more than half, 52.99%.

The write-down happened because DHFL failed to make some interest payment on time, which was treated as a default. DHFL subsequently made some payments but its financial future remains cloudy. The DHFL episode is the latest in a series of defaults and downgrades, starting in September 2018 with defaults by IL&FS group, an infrastructure conglomerate.

The current phase of the crisis is centred on non-banking financial companies (NBFCs) and housing finance companies (HFCs). Commentators have proposed a variety of solutions from the extreme (avoid debt funds altogether) to the complacent (do nothing). However, there is still merit in investing in debt funds, but you need to choose carefully.

Don’t run away

Investors fleeing debt funds for the safety of fixed deposits (FDs) due to ongoing market worries may be overreacting. The total assets under management (AUM) of debt funds is 13.24 trillion, about 51% of the total mutual fund industry AUM of 25.93 trillion. The debt fund AUM figure will go up if we include the debt portfolio of hybrid funds (which hold equity and debt). Mint estimates that mutual fund exposure to NBFCs and HFCs is 3.12 trillion (as of 30 April), down 17.6% from 3.79 trillion in September 2018. Only a few of these NBFCs and HFCs are facing difficulty making debt repayments. NBFCs include marquee names such as HDB Financial Services (a unit of HDFC Bank) and Bajaj Finance Ltd which are not in poor financial health.

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The potential of debt funds to give higher returns than FDs remains intact. The one-year average return on liquid funds (one of the lowest-risk debt fund categories) is 6.99%, for three years it’s 6.79% and for five years, 7.42%. In comparison, the one-year FD rate State Bank of India Ltd offers is 7% and the three-year rate is 6.75%. However, many people invest in debt funds with the dividend option. Dividends on debt funds are taxed through dividend distribution tax (DDT) at a rate of 29.12% (including surcharge and cess), which is lower than the highest marginal rate of tax at 31. 2% which is applied to fixed deposit interest of taxpayers in the highest bracket. If the debt fund is held for more than three years, it enjoys a capital gains tax rate of 20% with the benefit of indexation. This often takes its post-tax return higher than that from FDs. Some debt fund categories even deliver higher pre-tax returns than liquid funds, increasing the advantage over FDs.

Size matters...

Small debt funds have taken the maximum hit from the debt crisis. Large funds have also had exposure to some of the troubled groups, but their sheer size cushioned the impact to a large extent. For example, the size of some of Franklin Templeton Asset Management (India) Pvt. Ltd schemes shielded them from heavy losses though they had exposure to the Essel group. Individual debt papers, typically, have a ticket size of around 5 crore; this means that a scheme needs to be at least 100 crore in size to keep exposure to one particular paper low.

This problem has particularly affected fixed maturity plans or FMPs, many of which have portfolios in the 50 crore- 100 crore range. This is a result of the short window period in which they are able to collect money from investors. After the launch period, they are closed for fresh subscription.

Many of the small-sized funds that were hit by bad debt were not small to begin with, but became so when investors, worried by their holdings, exited them. “MF research teams at major institutions noted the issues in these DIE companies (DHFL, IL&FS and Essel) and informed clients to enable them to take portfolio action," said Gautam Kalia, head, investment solutions, Sharekhan, a subsidiary of BNP Paribas and a leading stockbroking company.

For example, DHFL Pramerica Ultra Short Term Fund saw a 91% drop in its average AUM between March 2018 and March 2019. This is another factor that investors should keenly track. A mere 2% exposure to a troubled company can become 20% in a matter of months if money flows out of the fund. This is because the funds involved, typically, do not sell the bad debt in question to avoid crystallizing what may have been a paper loss. They also may not find sufficient liquidity or have a market at all to sell the paper.

... so does category

The Securities and Exchange Board of India’s (Sebi) classification of October 2017 created several fund categories defined in terms of the maturity of papers held by them, but specified nothing about the credit quality of these papers. Specifying maturity length takes care of interest rate risk (the risk of bond prices falling when rates rise) but does not address the risk of the issuer being downgraded or defaulting. Before the credit crisis, it was common for distributors and investors to ignore the credit risks of funds falling in fund categories like ultra short duration, short duration, low duration and medium duration.

If you wish to minimize your risk, you can deal with the issue by sticking to certain categories where the credit quality is demarcated. For instance, corporate bond funds are mandated to hold 80% of assets in AA+ and above instruments, while banking and PSU debt funds focus on the debt of government-owned companies. This is not foolproof and schemes in both categories have been hit by bad debt but it can act as a filter in your scheme selection process.

“Investors looking to absolutely minimize risk should move to overnight funds. They can also choose these funds for STPs (systematic transfer plans) into equity funds, rather than liquid or ultra short-term funds," said Dhaval Kapadia, director, investment advisory, Morningstar Investment Advisers India Pvt. Ltd. If you are willing to stomach the risk, you can go for categories like credit risk funds, but be fully prepared to stomach losses from bad debt, should they arise.

To sum up, investors should not tar the entire debt fund space with a single brush. There are good and bad funds, and these can be identified. Remember that the tax advantages of debt mutual funds have not gone away. Such funds can also deliver better pre-tax returns than fixed deposits.

Though there are debt problems in some of India’s corporate groups which can cause further losses in debt funds, investors can minimize these risks by picking large funds which are not seeing significant depletion. In addition, they can monitor portfolios in terms of credit quality and diversification or pick categories like overnight funds that are structured to minimize risk.