How to deal with debt-fund downgrades

40-odd MFs suffered overnight blips in NAVs after rating agencies slashed the credit ratings of IL&FS and its group entities

How should investors react to sudden NAV losses caused by defaults or downgrades of bonds in the debt funds they own? This question has cropped up again after 40-odd debt mutual funds suffered overnight blips in their net asset values after rating agencies sharply slashed the credit ratings of IL&FS and its group entities a week ago.

What happened

Project financier IL&FS and its key subsidiary IL&FS Financial Services enjoyed high investment grade credit ratings for their bonds (AA+ on NCDs (non-convertible debentures) and A1+ on commercial paper) until the end of August 2018. In September, reports surfaced that IL&FS Financial Services had failed to repay its commercial paper dues, while IL&FS had defaulted on deposits due to Small Industries Development Bank of India (SIDBI).

Rating agencies, thereafter, slashed the credit ratings for the two firms by several notches at one go and followed this up by marking down both firms to ‘default’ grade. Other group firms, which had lower ratings to start with, were also downgraded.

Now, August-end data suggest that about 40 debt mutual funds held bonds from IL&FS or its group entities, with exposures of 0.2-10 per cent. As debt valuation rules typically require mutual funds to write down the value of a bond by at least 25 per cent if it loses its investment grade status, funds holding IL&FS exposures took a hit of 0.05-2 per cent on their NAVs, immediately after the downgrade.

What to do

If a debt fund suffers a sudden setback to its NAV, your first instinct may be to exit it in panic. But past episodes of credit downgrades suggest that when a default hits a debt fund, three things may happen.

One, after writing down the bond’s value, the scheme may end up recovering a part or whole of its dues. In this case, the fund’s NAV will recoup and investors who exited the fund in panic will lose. Two, a further deterioration in the bond’s credit profile can force the fund to take further hits to its NAV. But when a bond is already rated default grade, investors in the fund have already lived through the worst-case scenario and have nothing to gain by exiting. Three, in rare cases, the asset management company (AMC), to protect its reputation, may bail out the scheme by acquiring the bond. Here again, investors are protected from any further downgrades and have no reason to jump ship.

Risks can lurk anywhere

Investors looking specifically for credit-risk funds have no reason to react to downgrades because if they seek higher returns from high-yielding corporate bonds, they must be prepared to take the downside risks that come with it, too.

But the IL&FS episode has shown that credit risks in debt funds need not lurk only in specially named ‘credit-risk’ funds. Of the 40 debt funds that carried an IL&FS group exposure, only six were credit-risk funds; the rest were liquid, low, ultra-short, short- and medium-duration and corporate bond funds, and fixed maturity plans (FMPs).

Investors in some of these categories, especially liquid and ultra-short funds, may have been ill-prepared for NAV blips arising from downgrades or defaults, and they must now look for funds with more treasury bills, or top-rated corporate paper in their portfolios.

But then, the IL&FS episode shows that credit-rating agencies are not infallible judges of credit-worthiness. And AMCs, despite dedicated credit teams, can suffer from the same biases as rating agencies in evaluating big-name issuers.

Therefore, bank-deposit investors who switch to debt funds for better returns and tax efficiency must keep in mind that credit risks may not be zero even in the safest categories of debt funds.

Watch out for concentration

After media reports on IL&FS, AMCs have come up with a variety of clarifications on their IL&FS holdings. Some have stated that their bonds are secured by project cash flows or backed by State governments. Others have said they have recovered part of their dues. Given that IL&FS had literally scores of group firms whose bonds were bought by debt funds, it is impossible for a lay investor looking at a debt fund portfolio to understand all these nuances.

But an easier check for investors to run is on the concentration of holdings in their debt funds. In the IL&FS episode, over 25 of the 40 funds got away with a minor hit to their NAV, because they held less than 3 per cent exposure to the group. Funds that suffered NAV hits of 2 per cent-plus had concentrated 9-10 per cent to IL&FS entities. Therefore, to stay off credit risks, investors must avoid debt funds with concentrated bond holdings.

Don’t chase yields

An obvious final takeaway for investors is that higher yields in debt investing always go with higher default risks. If you find a debt fund offering far higher yields than the prevailing government security yield, that’s an immediate sign of the additional risk you’re taking on. You would be better off with consistent middle-of-the-road performers than top-ranking funds for the last one or three years.

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