What are 5 important factors to look in debt mutual funds: 2

Debt mutual funds are great investment options for getting stable returns with lower downside risks. Debt funds offer a large variety of solutions for wide range of investment needs e.g. liquidity, investment tenures and risk appetites. However, based on comments and queries received by us at Advisorkhoj, we think that many retail investors lack the basic understanding of these funds and are unable to make informed investment decisions. In this two part blog post, we are discussing five important factors that you must understand and evaluate when selecting the right debt fund for your own specific investment needs.

In the first part of this two part blog post, What are 5 important factors to look in debt mutual funds: Part 1, we discussed three important factors in debt fund investments viz. Expense ratio, Modified duration and Yield to Maturity and how to invest accordingly. In this part, we will discuss two more important factors involved in debt funds, credit risk and concentration risk.

What is Credit Risk?

Credit risk is a hot topic now in the debt mutual fund space. Over the past 12 months, numerous debt mutual fund schemes were impacted by credit rating downgrades or defaults. While we have always stressed about credit risk in our blog, the last 12 months or so have been eye opener for many investors as far as credit risk is concerned. Credit risk refers to the risk of financial inability of the issuer of fixed income securities in servicing their debt obligations i.e. make interest (coupon) payments and / or principal repayment on the maturity of the security.

In the past, when times were good, debt issuers usually were able to raise financing from banks to meet their current debt obligations even if their earnings were not sufficient to make interest and principal payments. With access to money, balance sheet strength notwithstanding, issuers were able to make even high yield debt payments. Investors were happy and not really bothered about credit risk. Over the last few years, with the NPA crisis in our banking system, the situation has changed dramatically. Credit was (and still is) difficult to come by and many issuers were staring at the prospect of default. In the past 12 months, the debt market was rocked by a series of high profile defaults and debt mutual fund investors bore the brunt.

Regulation changes made by SEBI with respect to debt mutual funds has also made credit risk a serious concern even for so called safe funds like liquid funds. Previously debt funds were allowed to use straight line amortization method for Net Asset Value (NAV) accounting for securities below a certain maturity. Straight line amortization method of accounting made the NAVs of liquid funds very stable and investors got steady returns, even if credit ratings and market yields of the underlying securities of the schemes changed.

Earlier this year, SEBI has asked the Asset Management Companies (AMCs) to dispose-off with straight line amortization for all securities with maturities of more than 30 days and use marked to market method (based on daily market valuations). This has made liquid funds more volatile. Now SEBI has proposed to do away with amortization entirely for all maturities. Market valuations of debt securities depend on credit risk (credit ratings). Hence credit risk is now relevant for all types of debt funds and investors must give its due importance.

Rating agencies like CRISIL, ICRA etc., assign credit ratings to different debt papers (debentures, CPs etc.) to indicate their credit risk assessment of the papers. The table below describes the credit rating scale used by CRISIL to rate fixed income securities.

Lower the rating of a fixed income security, higher is the yield. Yields on A rated papers can be 175 to 200 bps higher than that of AA rated papers. Similarly the yield spread between A and AAA rated papers can be 200 to 225 bps. While lower rated papers can give higher returns, we will reiterate what we stated earlier in this post. If the credit rating of a security gets downgraded then the price of the security and NAV of the fund will drop. While interest rate risk is temporary, credit risk is much more permanent in nature. Therefore, due consideration must be given to credit risk.

You can get the credit ratings of underlying securities of a scheme in the monthly factsheet released by the AMCs. You can also refer to third party research websites for credit quality profile of debt funds. As mentioned earlier lower rated papers give higher yields but you should invest according to your risk appetite. We must state here that not all lower rated papers get downgraded but the probability of downgrade is much higher for lower rated papers compared to highly rated papers. If you have a low appetite for credit risk it is recommended that at least 70 – 80% of the scheme portfolio should comprise of high credit quality papers e.g. G-Secs (no credit risk), AAA and AA. While probability of downgrade is lower for higher rated papers, it is not outside the realm of possibilities. Therefore, you should monitor the credit quality profile of your debt schemes on a regular basis. Credit ratings can go up or down and you should not act in haste. However, if you see continuous deterioration of credit quality over several months, then you should put the scheme on your watch-list and consult with your financial advisors with regards to the appropriate course of action.

Concentration risk

Concentration refers to the proportion of holding in one specific bond, higher the concentration in a particular security, higher the risk. For example, if you hold a 10 per cent exposure in a single security and if it defaults, the NAV (net asset value) of the fund would fall to that extent. Even if the said security is highly rated e.g. AAA or AA, it can for any unforeseen reason get downgraded and investor returns will be impacted.

Investors must avoid concentration risk. After all, the most important purpose of investing in mutual funds is diversification; concentration is the opposite of diversification. Over the past few years SEBI has introduced several norms for reducing concentration risk with respect to issuers, sectors etc. This will make debt mutual funds safer for investors, but you should also do your homework when making investment decisions. Different investment experts have differing views on concentration risks but all agree that you should not take too much risk. You should have an intelligent and logical approach towards concentration risk. For example, Government securities and PSU debt securities (which enjoy quasi sovereign status) have very little or no credit risks. If these securities have relatively high concentration in the scheme portfolio, there should be no concern from a credit risk standpoint.

For other securities, 2 – 3% concentration limits are recommended for conservative investors. There are no hard and fast rules, but you should avoid having high NCD / CP concentrations like 9 to 10% or more, which in adverse situation however unlikely, can wipe out the accruals from the rest of the portfolio and result in a loss for you. You should discuss with your financial advisor and have a thoughtful approach towards concentration risks.

You may like to read: Do you know how to select debt mutual funds – understanding the risk

Summary

In this part of our two part blog post on debt mutual funds, we discussed credit and concentration risk. These two factors are largely interrelated as well. We devoted the largest portion of our two-part post on these two factors because they are most relevant in the current situation and will continue to be important in the future as well. To summarise, Expense ratio, Modified duration, Yield to Maturity, Credit and Concentration risks are the 5 most important factors in making informed fixed income investment decisions. We hope that you will be able to apply learning from this post in your fund investments and make informed decisions. You should also consult with your financial advisors before investing in debt mutual funds.

Suggested reading: What should be your debt mutual fund investment strategy in current economic climate