How to pick low-risk debt mutual funds

Debt funds, despite claims, are not completely risk-free. Here are a few factors you should consider while selecting these schemes

The uncertainty created by the IL&FS crisis in the bond market last month has made debt-fund investors jittery. While many debt funds, including liquid funds, witnessed a drop of over one per cent in their NAV (net asset value) on the day the IL&FS bonds were downgraded, the NAVs of some funds fell further by up to 5.7 per cent in the following days as IL&FS Financial Services, a subsidiary of IL&FS whose instruments these debt funds held, defaulted on its commercial paper repayments.

Over the past three years, there have been five such instances of rating downgrades and defaults that resulted in erosion of investor wealth in the mutual fund sector. With the frequent recurrence of such episodes, what steps should investors in debt mutual funds take to protect themselves? What checks have to be run before selecting the funds? And what are the safest debt funds available currently?

Note the risks

While debt funds are often sold as an alternative to bank fixed deposits, the former are not entirely risk-free. Though they may not be as risky as equity funds, they do come with the risk of capital erosion. These funds invest in various fixed-income instruments such as government bonds, corporate bonds, and money market and short-term debt instruments. There are two primary risks associated with debt funds — interest-rate and credit.

Interest-rate risk

Interest-rate movements in the economy can impact bond prices and, in turn, affect the performance of the funds investing in these bonds. If interest rates move up, bond prices fall. This is because investors flock to newer bonds that offer higher rates. So, the attractiveness of older bonds with lower rates goes down and their prices decline. Of course, when interest rates fall, bond prices, too, move up.

Fund managers of debt funds try to capitalise on the rise and fall of interest rates, an approach called duration strategy. In a rising-interest-rate scenario, the fund manager reduces the duration of the fund to cap losses (sells longer maturity papers and accumulates shorter maturity papers). During falling rates, long-term debt instruments are preferred.

For instance, interest rates in India have been at elevated levels over the past year. The falling rupee and the rise in crude prices have resulted in the yield on the 10-year government bonds moving up sharply by about 140 bps in this period. In this rising-rate scenario, most of the duration-strategy debt funds tend to generate negative or low returns.

Long-duration, medium-duration and gilt funds delivered -0.6 per cent, 3.5 per cent and -0.7 per cent, respectively, over the past year. On the other hand, when rates fell in 2014, these funds delivered an absolute return of 18 per cent, 11 per cent and 19 per cent, respectively. Hence, duration funds are suitable for investors with medium-to-high risk profile who are ready to accept some loss due to interest-rate movement.

The risk associated with interest rates can be eliminated by following the accrual strategy, which is nothing but capitalising on interest receipts rather than gains from bond prices. Accrual funds hold bonds till their maturity; hence, they are less impacted by interest-rate risk. Many debt funds, including overnight funds and liquid funds, follow the accrual strategy. Investors with a low risk profile can opt for such funds.

However, most debt funds follow a blend of the two strategies — duration and accrual — to maximise returns.

Credit or default risk

Credit risk is associated with the financial stability of the company that issues the bonds. If the company defaults on its interest or principal repayment, this will impact the NAV of the debt fund that has invested in the bond. Even if a bond does not default on its payment, rating agencies can downgrade the rating on these bonds. This can also mark down the value of the fund’s NAV.

As mandated by SEBI/AMFI (Association of Mutual Funds of India), while calculating scheme NAVs, mutual funds follow a valuation matrix prescribed by rating agencies for valuing corporate papers and mark-to-market gains/losses. Factors such as credit risk, interest risk and liquidity risk are considered.

A rating downgrade by a single notch (for instance, from AA to AA-) results in the bond yield increasing by 20-30 bps. When a bond defaults, the NAV of the fund is marked down by at least 25 per cent of the bond value.

Many funds allocate some portion of their assets in AA and below-rated debt papers to earn a higher interest. Lower-rated papers carry higher coupon rates than higher-rated papers. This hunt for higher yields is beginning to weigh on debt funds since instruments offering higher rates are mostly the ones that carry a relatively higher probability of default.

History repeats itself

In mid-2015, two debt schemes from JP Morgan MF fell 3.4 per cent and 1.7 per cent in a day when Amtek Auto bonds were downgraded. The AMC then managed to sell the troubled debt paper at a 15 per cent loss, according to sources. In February 2016, when CRISIL downgraded the long-term rating of Jindal Steel and Power to BB+ from BBB+, a few funds from ICICI Prudential MF and Franklin Templeton MF fell by up to 1.6 per cent in a day.

In February 2017, four debt schemes from Taurus MF posted huge losses (fell 7-12 per cent in a day) after India Ratings downgraded ratings on Ballarpur Industries. In May 2017, when ICRA downgraded IDBI perpetual bonds, a few funds from Reliance MF and Aditya Birla Sun Life MF took a hit, albeit marginal.

This time around, 22 schemes, including two liquid funds, have been hit after credit-rating agencies downgraded the ratings of debt securities issued by IL&FS and its subsidiary IL&FS Financial Services. These schemes witnessed a further drop in their NAV in the following days as the IL&FS defaulted on its commercial paper redemption. The schemes that have been hit badly (between September 7 and 28) are Principal Cash Management (-8.1 per cent), Motilal Oswal Ultra Short Term (-6.1 per cent), Principal Ultra Short Term (-5.2 per cent), DSP FMP 195-36M (-4.7 per cent) and Aditya Birla SL FTP-OW-1245D (-3.7 per cent). A few other funds, too, are likely to be hit even more going ahead, as they still hold NCDs (non-convertible debentures) and commercial papers issued by IL&FS and its subsidiaries.

Although debt funds are relatively low-risk, managing risks is a tricky affair. The issue with IL&FS bonds is that the ratings of its short-term debt papers were downgraded several notches — from the highest A1+ to the lowest grade of D — in a span of 42 days. This shows that rating agencies and the in-house risk control system of mutual funds cannot be fully relied upon to safeguard investors’ money.

The problem is that almost all debt categories, including many liquid funds, invest in lower-rated debt papers to chase higher yields. The above instances highlight the conflict between the investment objective and the portfolio positioning of various debt mutual fund schemes, especially liquid funds. Ideally, liquid funds should ensure the safety of investors’ money and the portfolio should have very high liquidity, minimum volatility and near-zero chances of capital loss.

Fund selection

While selecting debt funds, there are a few factors that conservative investors can consider to ward off undue risk. Here they are:

Large corpus

It is better to select debt funds with a large corpus since they have many advantages. One, the fund manager can bargain for better yields with the bond issuers. Two, since institutions dominate debt-fund investments, the redemption amounts could be large. So, funds with a higher corpus can meet such sudden and large redemptions more easily. Three, fund managers can spread the assets over a larger number of securities. The Table lists debt funds with a corpus of more than ₹5,000 crore (median corpus in the last 36 months).

Allocation to highest-rated papers

It is also good to scan the fund portfolio to check the allocations to top-rated bonds. Barring the IL&FS issue, most downgrades have occurred in lower-rated papers.

Funds with high allocation to AAA/AA+/A1+ debt papers are relatively insulated from risk. Similarly, make sure that investments in AA and below-rated papers are minimal.

Diversification

Diversifying assets across a large number of securities in a portfolio will mitigate the loss from a single security as it is averaged out with the gains from other debt instruments. Since there is no optimum number of holdings in a portfolio to provide calibrated diversification, debt funds with more than 80 securities can be considered relatively safer.

Low concentration

If a holding in a single paper forms a large part of the corpus, the fund is exposed to higher risk. Therefore, debt funds that have not invested more than 5 per cent in a single security are safer. Such low concentration helps mitigate the risk of the portfolio.

Our Picks

We have attempted to arrive at a preferred list of low-risk debt funds based on the criteria described above. Our picks are listed in the adjacent Table. The one-year rolling return of a four-year period was considered for the selection. We analysed the past five years’ portfolio and have picked funds that predominantly invested in highest-rated papers. We have also included funds that invested only up to one per cent in lower-rated papers.

 

The list is not entirely risk-free. It comprises liquid funds including DHFL Pramerica Insta Cash, UTI Liquid Fund-Cash, Invesco India Liquid and Reliance Liquid funds. They invest only in debt securities with a residual maturity of less than or equal to 91 days. With the maturity period being short, both interest-rate risk and credit risk are minimal. Liquid funds are designed to meet short-term cash and contingency needs, and are positioned as a substitute to savings bank accounts and fixed deposits.

Click here to read table

However, ultra-conservative investors can consider investing in these funds either to park their short-term money or as part of their long-term debt portfolio.

Conservative investors can also look at overnight funds, which are considered the lowest-risk debt funds in the MF universe, as they invest in very short-term debt papers, including CBLO (collateralised borrowing and lending obligation) and market repo maturing in one to three days. Currently, the weighted average rate of CBLO is 6.3 per cent, and it has hovered at 4.3-6.6 per cent over the past year. Hence, the returns from these funds are closer to these rates.

Investors with a a low-to-medium risk profile can also look at the funds shown in the list that includes money market funds (ICICI Pru Money Market), corporate bond funds (IDFC Corporate Bond and HDFC Corp Bond) and short-duration funds (Reliance Short Term and IDFC Bond Fund - Short Term).

Please note that these funds follow both accrual and short-duration strategy; hence, they are exposed to interest-rate risks.

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