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  4. How to identify risks in debt funds

How to identify risks in debt funds

April 27, 2020

risks in debt funds

Our comprehensive report yesterday gave you a detailed list of funds across AMCs with higher credit or concentration risk in each category. With the help of our MF review tool and the pointers we gave you, we hope you identified the ones you need to move out of. If you have not, please read the article here if you are a subscriber or subscribe today to ensure you are with the right debt funds. 

Despite the detailed effort, it is not a fool-proof list as there may be risks even in AAA or AA+ rated instruments that we don’t know yet. Also, this exercise may have to be repeated, for every fund you hold and every fund you add. So it becomes important to identify risks. 

Identifying risks in debt funds

Many of you ask us on how to identify these risks. Truth is, it is extremely hard. We will list down some of the points here and you will know why.

  • Credit risk can be extremely fruitful in a high growth periods of the economy, providing steady accrual, no negative returns, low volatility and so on. At such times, a fund’s performance entirely masks risks, whatever ratios or metrics you use. This is why many fund ratings fail to capture it oftentimes and you end up picking them. It takes severe NAV hits for a rating system to show the impact or it takes careful construction of weights to capture changing credit movements in a fund. A rating exercise using performance metrics alone is a postmortem unless returns are steadily rolled every day to capture changes.
  • Defining credit risk is very hard. SEBI has categorized it as those with AA+ rating and above. But papers that were AAA-rated like IL&FS turned bad. Papers that were AAA or AA+ and liquid like DHFL lost their liquidity in no time. Hence, how do you wish to define credit risk?
  • Even assuming that you carefully scrutinize portfolios every month, it is not easy for you to identify different papers that may actually belong to the same group and hence up group concentration. IL&FS, DHFL and Essel (Zee group) are classic examples. There continue to be such instances of myriad papers belonging to the same group. In order to identify them, you will need to pull out their rating rationales and make the connection.
  • Liquidity risks can show up with climbing redemption of a fund. This can sometimes happen in matter of days and weeks and not in a month end when portfolio data is available. Similarly, when a fund has high negative net cash it may suggest borrowing for meeting redemptions. But negative net receivables can occur for other reasons such as a fund using interest rate derivatives. It is not easy to identify real risks.

The above will tell you that it takes time and effort to unearth risks in debt funds. So it is a difficult task auditing this. Instead, first define what risk means to you, in debt.

Answer to yourself this question – why are you in a debt fund?

  1. If it is to get FD-like steady returns with no falls – stick to overnight or liquid funds over and above deposits. There is almost nil credit risk here and little volatility related to bond price movements.
  2. If it is for asset allocation with your long-term equity portfolio – gilt funds, high-quality bond funds/PSU bond funds (of different average maturities, depending on your timeframe) would do. This is what we have done with our 7-year plus portfolio. Should you up the risks that you are already taking in equity by going for riskier debt funds? For most of you, ‘yes’ will not be the answer to this question. So don’t try to aim for high returns at all times.
  3. If you are in debt funds for tax efficiency or higher returns than FD – ask yourself whether you can handle declines and volatility in returns in debt. If yes, can you wait long enough for a recovery? If you cannot, stick to what we mentioned in point 2. Choose the category based on your time frame.
  4. If you are still a risk taker – yes, take the risk by investing in a credit-heavy fund. But first understand what risk you are taking and keep a long time frame for accruals to heal the wounds of downgrade in a fund’s debt papers.

Even then, you may have the misfortune of deep hits like the case of ABSL Medium Term or ABSL Dynamic Bond or closure of Franklin India Ultra Short Bond. This, even if you had stayed with the fund for 5-10 years! Such a risk, even time cannot heal. So again, understand what you are getting into. If you have high risk funds in debt, ensure that you have some emergency funds in safe options.

Check out our review tool!

Our MF review tool will keep your portfolios in ship-shape. With specific buy-sell-hold ratings for funds, you’ll always know where you stand. Try it today!

What is the way out?

The general guidelines given above will help you be better prepared in debt fund investments. Over and above these, the tips below will help you manage your investments better.

  • Keep exposure to even high quality funds at 10-25% of your overall MF investments. This will de-risk your portfolio and shield it from unforeseen, one-off events.
  • Diversify across fund houses. Unlike equity, duplication of strategy does not matter with debt. An AMC’s  ability to handle liquidity crisis may vary. AMCs also tend to hold similar papers across their funds, so trouble in one paper can affect multiple funds.
  • Any hint of credit risk in funds meant for less than 2 years is best avoided. (check our definition of what is credit risk in the ultra short/low duration/money market categories in our earlier report)
  • For other categories where you see risks but you are happy with fund performance, keep exposure to less than 10% if your time frame is over 3 years. Exit if your time frame is shorter than this.
  • Government bonds and most PSU bonds suggest better liquidity. If your fund portfolio is filled with these, there will be interest rate volatility but your money will be safe as the volatility settles with passage of time.
  • Keep watch of any sharp decline in your fund AUM size across months. Some volatility in AUM is inevitable in liquid and ultra-short (and similar) categories as corporate treasury money constantly moves in and out of these funds.
  • When you enter credit risk category, know that you are taking far higher risks than perhaps even equity. In our opinion, it is not worthwhile.
  • When your wealth growing years moves to an income requirement phase, it is best to shift most of your money to deposit and government schemes. There is no such thing as 100% capital preservation in debt funds.

Having said all this, we also wish to say that it is important  to stay grounded and not panic into entirely moving out of your debt funds. You may incur huge taxes and exit loads. If your fund holds a majority in high-quality debt, either of AAA-rated corporates, PSU companies, banks, other government institutions and so on, your fund has minimal risk.

We will be following debt funds for both risk and return parameters and will also closely watch for AUM falls and redemption pressures. If we see risks going up, we will sound you off on them.

Still, we cannot be invincible! We can identify performance dips well. We can identify most risks but not all. It is hard for us to identify sudden liquidity pressure triggered by redemptions. We can never identify risks such as a fund house closing down flagship schemes suddenly. 😊 But we will try to do this to the best of our knowledge and ability.

Please keep yourself updated on all our articles to stay with good products.

Post script

Other reports we have done on the fallout of Franklin Templeton’s debt fund closures are as follows: 

  1. https://primeinvestor.in/franklin-funds-are-winding-up-will-you-get-your-money-back/
  2. https://primeinvestor.in/how-primeinvestor-identifies-risk-in-debt-funds/
  3. https://primeinvestor.in/franklin-debt-funds-from-other-amcs/
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