COVID-19 effect: Debt funds in turmoil, check credit risks

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April 28, 2020 3:30 AM

As credit risk funds may see redemption pressure because there are no takers for lower-rated paper, investors can opt for liquid and overnight funds.

The fund house had to take the extreme decision because of the redemption pressure and illiquidity caused by the Covid-19 pandemic.

All investors of debt mutual funds, which have been seen as low risk, are worried after Franklin Templeton Mutual Fund announced its decision to wind up six of its credit risk fixed income schemes with net assets under management of Rs 25,900 crore. The fund house had to take the extreme decision because of the redemption pressure and illiquidity caused by the Covid-19 pandemic. Investors in these six schemes will be hit as the money will be blocked and no liquidity will be available in their portfolios. They may get payments in a staggered manner if the fund house is able to recover money after liquidating the investments.

Turmoil in debt market

Analysts say other debt schemes may see redemption pressure as the coronavirus pandemic has led to risk aversion amongst investors and there are no takers for lower-rated and unrated paper. The turmoil in the Indian debt market started with the Infrastructure Leasing & Financial Services (IL&FS) default in 2018 which led to a liquidity squeeze, and then liquidity-starved Dewan Housing Finance Ltd (DHFL) and many other companies defaulted on principal and interest payments. Before investing, investors must analyse the credit risks and interest rate risks of debt funds. They must also check the fund house’s investment portfolio—whether the bonds are from well-known companies—and be careful where the fund manager is chasing returns by taking higher credit risk.

Joydeep Sen, founder,, says what happened at Franklin Templeton was not only about the credit risk in the portfolio, but also about redemptions from the portfolio in apprehension of credit defaults. “One thing compounds the other. Had redemptions not happened to the extent it did, probably this extreme step would not have been required. It was possible to allow things to drift, without freezing the six funds. But then, investors who exited early would have got a ‘better’ exit and those who remained, would have been left with an inferior quality portfolio,” he says.

Liquidity issues

The corporate bond markets in India are fairly illiquid and even more so in the lower credit rating space. With rising redemption pressure, fund houses are not able to sell the bonds because of the poor liquidity conditions. Fund houses have also resorted to borrowing in order to meet the redemption pressure.

According to a research note by Morningstar Investment Adviser India, Franklin Templeton took several measures to meet redemption pressure by way of getting borrowers to pre-pay debt, selling bonds to banks and using the credit line provided by banks. “However, with unprecedented high redemptions from these funds, it came to a situation where these were not viable options anymore,” it says. In March alone, cumulatively, these funds witnessed an estimated net outflow of Rs 9,148 crore.

In the current context, investors should look at liquidity risks of the funds, which means how quickly the fund manager can sell the particular paper in case of any downgrade. Corporate bonds of high-rated companies are more liquid than the lower-rated paper. If the fund manager is selling the paper under pressure, then investors will suffer losses. In fact, savvy investors have been exiting from credit risk funds as the AUM fell to `55,381crore in March this year from Rs 65,124 crore in October last year. The number of folios dropped to 4,61,927 from 5,19,311 during the same period.

Credit risk

Corporate debt paper carry higher credit risks than government bonds. Credit risk takes into account whether the bond issuer is able to make timely interest payments and pay the principal amount on maturity of the bond. If the issuer is unable to do so, then the particular bond is likely to default.

Investors should not invest in funds that have high exposure to companies having a large leverage. If you invest in debt funds, align investment horizon with that of a fund which will help to mitigate the interest rate risk. Sen says in case there is panic redemption across the industry, then the issue that happened at Franklin Templeton will spread to the entire industry and will ultimately harm the investors. “The panic exit will happen at higher bond yields i.e lower prices. The RBI Special Liquidity Facility (SLF) window of Rs 50,000 crore for mutual funds should help assuage sentiments,” he notes. Schemes like liquid funds and overnight funds are less risky than credit risk funds.

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