Primer. Picking debt funds across the credit spectrum

Mutual funds offer debt schemes across the credit spectrum. Funds that invest in Central government treasury bills (T-bills) carry relatively lesser credit risk, followed by short-term gilt funds and banking and PSU debt funds.

The safety of the capital comes at a price. The returns are relatively lower, though that does not completely eliminate default risk. Many of these funds invest in State government securities, which are not guaranteed by the Central government or the RBI. While most banking and PSU debt funds stick to a portfolio as evident from their names, some have a leeway to invest in corporate debt as well.

Barring some issues in the cooperative banking sector, India has rarely seen a bank default. Sometimes the government steps in to facilitate the merger of a weaker bank with a stronger one, to protect depositors and prevent panic in the industry. By and large, banking and PSU debt funds have a conservative portfolio.

As we move further across the credit spectrum, we come to liquid funds, ultra short-term funds, short-term and income funds. Corporate bond funds follow these in terms of relative credit risk.

Credit rating is available for the underlying investments of a fund, with the rationale for the rating in the public domain. Investors need to make their own judgment on the quality of the portfolio.

While credit rating is an important input, it cannot be the sole criterion for an investment decision. The rating industry’s fault lines came to the fore in the 2008-09 financial crisis in the US.

At the far end of the risk spectrum are the credit opportunity funds, which dangle attractive returns. Investors need to assess the risk versus return trade-off and make a decision based on their risk appetite. Such funds get tested when the economic cycle turns for the worse or when the financial markets face a crisis. A one-off credit default can also burn investors.

The structure of the debt fund industry exposes investors to inherent liquidity risk. The vast majority of funds are open ended, offering redemption typically within one working day.

The assumption is that the underlying investments are liquid and have a ready market.

Debt markets in India have a long way to go to reach that level of maturity. The industry went through a trial by fire during the major crisis in 2008-09; in the first half of that financial year debt funds saw an unprecedented net outflow of more than ₹50,000 crore amid a stampede for exits.

The central bank stepped in and infused liquidity through a special 14-day Repo and other measures for mutual funds through banks. Investors emerged largely unscathed. However, it is imprudent to assume a central bank-led bailout every time crisis strikes.

A post financial crisis credit default event in an auto components company in 2015, and its impact on some debt fund schemes, reveal the continued risks in the industry. Stock market regulator SEBI has now removed the wide latitude assumed by asset management companies to restrict redemption.

Corporate lending at banks, an area which overlaps with debt funds, has seen extraordinary stress and colossal levels of non-performing loans. Are debt funds immune to such stressed loan exposure?

Risk management will play a very important role in asset management companies to keep a check on the urge to offer higher returns and attract investors when the tide is rising.

When the tide inevitably ebbs, investors will no longer appreciate past returns on capital but will applaud those fund managers who redeem their capital promptly on request.

The writer is a freelancer

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