Mutual fund managers were jolted awake to one of the more underrated risks—credit risk. Investors’ goals have been punctured by a slew of defaults, and by what was thought to be safe, “AA" and above, portfolios.

It started with IL&FS defaulting, which is now turning into a bigger and wider crisis. Mutual fund investors were in for an even bitter surprise six months later, when innovatively structured deals that ended up with equity exposure to companies began to bite. Essel Group companies, of which Zee Entertainment is the flagship firm, came into the mix after repayments were missed late last year.

“Now the time of reckoning has hit home," says investor and market veteran Ajay Bagga. He notes that fund houses have lent through structures where even banks would think twice. “With non-reporting of promoter pledges, lending to subsidiaries that would not qualify for bank lending on standalone financials and with post-default standstill arrangements, we now have the makings of a full-blown credit crisis," said Bagga.

Fund managers have misread credit risk in a huge way. “Fund managers have clearly not grasped the credit risk. Innovative structures, such as these make sense for alternative investment funds, not debt funds," said Prateek Pant, head of products and solutions, Sanctum Wealth Management.

Non-payment by Essel Group firms has led to two fund houses reneging on payments on maturity to investors in their fixed maturity plans (FMP). FMPs are fixed-tenure debt plans that need to invest in debt instruments matching the life of the scheme.

But, of course, fund managers on their part, say that they should not be blamed. They take all measures to protect investor money by ensuring that the underlying security doesn’t lose too much value. “If the collateral is invoked by everyone, there is an even larger loss. It is to protect investors’ money that the standstill agreement made sense. The fund house is not gaining anything," said a debt fund manager, requesting anonymity. The standstill agreement between lenders and Essel Group promoters in January entails giving promoters up to September to repay lenders.

But the moot question is, why are fund houses taking unnecessary credit risks? Credit risks don’t spring out of the blue. There are enough cues and advance warnings that, if spotted and acted on early, can avert disaster. Another lesson is to know that invoked pledges can keep the markets on the hook. It’s not easy to sell large amounts of shares. A few days ago, a small block deal in a large bank sent the Bank Nifty on a tailspin. These are the questions investors should ask the credit committees of these funds.

In Bagga’s words, there is no cost to the AMCs, the rating agencies or the wealth advisers who pushed such products. Fund houses cannot hide behind the caveat emptor given the information asymmetry between them and retail investors.

Risks in the credit market can have cascading effects. Funds need to redraw clear lines regarding the risks they are assuming, and mutual-fund investors should follow suit by taking the correct exposure. For its part, the regulator needs to lay out proper risk framework so that the implied risk in a debt fund is not anything other than it is supposed to be.