Guard yourself from risks in debt funds

September 7, 2015 . Vidya Bala

The recent news of Amtek Auto’s problems with its debt and the holding of its debt instrument in a few mutual fund schemes raised a debate on whether debt mutual funds are indeed safe. While such a debate may be a never ending one – it came up during 2008 FMP troubles, 2013 liquid fund mark down and now – let us focus on what you as an investor can do to limit your own risks with debt funds.

When we say ‘limit’ your risk, we clearly mean that debt space is not devoid of risk. While the risk arising from interest rate cycle, called the duration risk, affects most medium to long-term debt funds, credit risk (risk arising from exposure to debt instruments companies that do not have top credit quality) is a conscious decision that fund houses choose to take and therefore does not affect all funds.

While you have little choice but to ride out duration risk, if you take it, here are ways to limit credit risks in debt funds.

Time frame based category choice
With equity funds – your time frame is clear – it has to be long term. However, with debt funds, time frame has a large role to play in the choice of your funds and thereby the risks you assume. When you have a short time frame – you cannot be taking duration risks or credit risks. You need to be reasonably sure of getting back your capital and in that process earn returns slightly better than other liquid options such as your saving bank account rate.

In other words, if you have a short time frame of say less than 1 year, you should be happy to stick to liquid and ultra short-term funds and not venture beyond that. These categories have low-risk papers and even if they do have commercial papers of corporates, their duration is very short to balloon into unforeseen risks.

Avoid pure credit strategies unless you understand them
In recent years, there have been a number of funds that have a stated strategy of digging deeper into the credit space for higher yields or looking for temporary mispriced opportunities in the corporate credit space. Either which way, unless you understand the overall credit cycle of the corporate world and whether you are riding on top or bottom of such cycle, it may not be a easy call to ride this high-risk category.

Investing in this category is akin to investing in sector funds in equity. You should know when to enter and exit and for that purpose understand the cycle of that sector.

Also funds with such strategies would sport a low to medium portfolio maturity but require a reasonably long time frame overall for the accrual to deliver. So even if there is mismatch of time between your own horizon and what the fund ideally requires you to hold, you may lose. Long story short, this game is not for everybody. And definitely not for those merely using debt for asset allocation purpose.

So how should you take exposure to corporate opportunities at all? Move on to the next point.

Play it safe with ‘diversified’ debt funds
If you have a medium to long time frame (2 years and over), look for a fund that has a diversified approach; that is, a mix of gilts, corporate bonds and some amount of short duration papers such as certificate of deposits and commercial papers. This should give you adequate exposure to corporate opportunities as well as play the duration game through gilt. Funds in the dynamic bond and income accrual category sport this kind of profile.

But then, one of the funds that had Amtek Auto was a short-term fund and ended with higher risks. What do you do about it? Here again, such rare instances are inevitable. You cannot be sure that every AAA or AA paper in of high credit standard. What you can do, though, is to ensure that single instrument exposure to AA-rated or lower instruments is not over 5-10% in the fund you choose.

When an illiquid bond instrument accounts for 10% of your NAV, then any default can hurt you. If it is lower at say 1 or 3%, less harm. Do a quarterly check or ask your advisor for one, to understand the fund you hold does not have such concentrated exposures.

Go for funds with larger AUM
As retail investors, you may be impacted by a large redemption placed by any institutional investor (who are major investors in debt funds), if the asset size of a fund cannot take that impact comfortably with sufficient liquidity.

Hence, look for funds (within the category fitting you) with large assets of Rs 1000 crore or over in case of liquid or ultra short-term funds and at least Rs 400-500 crore in case of other medium to long-term categories.

Don’t chase yields taking credit risk
When you see a fund with top returns in equity, you are tempted to pick it. The same happens with debt. When you see a fund delivering far higher than peers, you think it is a great fund. The question is whether it fits you.
No debt fund would be able to have a higher yield to maturity (the yield of instruments in the portfolio) unless it goes for risk or takes bets that the category, on an average, does not take. So a simple thumb rule is higher returns must come at higher risk. It may not be worth taking such risks if you chose debt to simply hedge your equity portfolio and provide some diversification.

Debt funds, as a category, are often misunderstood by retail investors, given that as an asset class, retail investors have not ventured much into it.

Remember, banks, whose primary job is to lend, have large NPAs in their books, despite all their due diligence. Hence, to expect mutual funds to be free of such issues would be unrealistic. Be surprised that mutual funds have managed to keep their ‘bad loans’ reasonably low.

As an investor, you do know that debt fund is a better vehicle to ride than traditional options in terms of returns and taxes. Events such as the present one will teach you to also ride it, with lower risks.

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