Fixed income: Know how downgrades impact debt funds

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New Delhi | September 18, 2018 12:53 AM

If the downgrade is for short-term instruments, you need not worry too much as maturity of these instruments is one or two months away. If it is for long-term bonds, then check the percentage of your fund’s assets invested in the bonds.

Among the various risks, one of the chief risks is downgrading which is not noticed by the investors. Let us discuss and understand the same. (Illustration: Shyam Kumar Prasad)

Often investors choose to invest in debt funds as they are less risky than equity funds. However, they are not entirely risk-free and there are various risks such as default risk, interest rate risk, reinvestment rate risk, etc., associated with debt funds.

Among the various risks, one of the chief risks is downgrading which is not noticed by the investors. Let us discuss and understand the same.

What is credit rating?
Credit rating is basically an assessment of the creditworthiness of a borrower or with reference to a particular financial obligation such as debt, bonds, commercial papers, fixed deposits, certificate of deposits, etc. A credit rating could be assigned to any organisation that borrows money and it could be for companies, state, sovereign government. Credit rating is based on various quantitative factors based on the financial statements and qualitative factors based on the interview and discussions with the key managerial personnel of the entity.

Credit rating agencies such as Standard and Poor’s, CRISIL, Care, Fitch, etc., assign different letter grades to indicate ratings. Each rating has a special meaning. For instance, the Standard & Poor’s credit rating scale ranges between AAA (excellent) and D. Any financial instrument with a rating below BBB minus is considered as junk bond or speculative in nature. Thus, one should invest in bonds or financial instruments with higher credit rating by the rating agencies.

Downgrade and its impact
Downgrading by the rating agencies happen mostly due to the risk of default which could arise from poor financial performance, falling cash and bank balance, rising further debt, reduction of debt service ratio, deteriorating business conditions and outlook. Any news about downgrade of any instruments, especially bonds, could lead to a fall in prices leading to loss for the investors.

These are unrealised losses, popularly known as marked-to-market losses. Sometime, a downgrade with ‘ratings watch’ indicates that the instrument could be further downgraded or default may be triggered in the near future.

For instance, when a downgrade is announced for a hybrid fund (partly in debt and partly in equity), the immunity part of the portfolio could register a reduction in value. When the downgrade is just one notch lower with an outlook for upgrade in the near future, one need not worry much as it could cause just some temporary volatility in the fund’s NAV.

To remain or to exit
The critical question is that when such a downgrade happens in a debt or hybrid fund, whether an investor should exit the mutual fund. Broadly, look at the following and then take a call. First, if the downgrade is for short-term instruments, you need not worry too much as maturity of these instruments is one or two months away.

If the downgrading is for long-term bonds, then check the percentage of your fund’s assets invested in the bonds. One can get this information from the monthly fact sheets. An exposure of 10-15% could be risky.

To conclude, whenever a downgrade happens to a debt or hybrid fund in which you have invested, look at the above aspects and take a decision to continue or exit from the scheme.

-The writer is professor of finance & accounting, IIM Tiruchirappalli

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