The spate of defaults and rating downgrades has made it clear about credit risk in debt mutual funds. Investors should not invest in funds that have high exposure to companies having a large leverage.
The trouble with debt mutual funds is aggravating by the day. Now, a series of debt funds have been hit hard after liquidity-starved Dewan Housing Finance Ltd (DHFL) missed principal and interest payments of `1,100 crore on June 4 on a set of outstanding bonds. Rating agencies have downgraded debt paper of DHFL, fund houses are creating segregated portfolio of securities of DHFL and the fall in the net asset value (NAV) of the funds have sent chills down the spine of individual investors.
Around 160 debt mutual fund schemes had exposure to the debt papers of DHFL worth Rs 5,236 crore as on April 30, 2019. In all, around two dozen fund houses including UTI Mutual Fund, Reliance Mutual Fund and Tata Asset Management have exposure to DHFL paper. In fact, as per the standard haircut table for sub-investment grade debt securities, UTI Mutual Fund had taken a 75-100% markdown to DHFL debt securities in the schemes that have an exposure to DHFL.
Wait and watch
The debt market turmoil started with Infrastructure Leasing & Financial Services (IL&FS) default last year which led to a liquidity squeeze. Last month, two Reliance ADAG companies—Reliance Home Finance and Reliance Commercial Finance—were downgraded to default grade. As per CARE Ratings, for the first time in six years, the number of downgrades is more than the number of upgrades.
Investors who have put in money in DHFL paper through the mutual fund will now have to wait and watch for the recovery. The company has said that it is trying to sell its assets to pay its debts. Fund houses such as Tata Asset Management Company have given the investors side-pocketing option in five funds—two in Treasury Advantage Fund, one in Medium Term Fund and two in Corporate Bond Fund. In side-pocketing, allowed by the markets regulator, the debt portfolios are segregated into two parts separating the troubled papers from rest of the portfolio.
In the last few months, debt schemes had to mark down the value of the affected securities. Fund houses have either rolled over the maturity date of the fixed maturity plans (FMPs) or allowed part redemption. Kotak Asset Management Company (AMC) deferred full redemption in six FMPs that held papers of two Essel Group subsidiaries. In fact, nine AMCs including SBI AMC, HDFC AMC, Reliance Nippon Life AMC, Franklin Templeton Asset Management (India), Aditya Birla Sun Life AMC and UTI AMC have lent to Essel Group across 87 schemes, including FMPs and open-ended debt funds. Even HDFC AMC has extended the maturity of one of its FMPs maturing on April 15, 2019 to April 29, 2020 citing current interest rate scenario and portfolio positioning.
Look at risks
Investors must understand that debt mutual funds are not risk-free. The spate of defaults and rating downgrades has made it clear about credit risk. Investors must also understand the interest rate risk, which is the fall in the NAV due to the interest rate scenario. Investors must understand these risks before investing in mutual funds, which are tax efficient as they provide indexation benefit on the gains after three years. However, debt mutual funds are not as safe as fixed deposits and if an investor wants the safety of capital it’s better to invest in bank deposits.
Experts say investors should not take too much risk to earn higher returns and should stick to funds which invest in AAA-rated securities. Investors should not invest in funds that have high exposure to companies having a large leverage. Higher the maturity profile of the fund, more prone it is to interest rate risk. So, any change in the price of a bond because of changes in the interest rate can affect investors.
In case of increasing interest rate scenario, it will be positive for funds having a shorter maturity profile. On the other hand, a falling interest rate scenario will be beneficial for those funds which have a longer maturity profile. So, if you invest in debt funds, align investment horizon with that of a fund which will help to mitigate the interest rate risk.