The debt funds debacle saga

The debt market has been witnessing trouble since September 2018. After the IL&FS default, the debt fund industry has been facing a credibility issue. “Almost 20% of debt funds assets were invested in non-banking financial company’s (NBFC) short-term papers and suddenly, the entire portfolio holdings of fixed income mutual funds have come under scrutiny of investors,” said Raghvendra Nath, founder, Ladderup Wealth Management.

The cascading effect of the IL&FS crisis was seen in NBFCS and housing finance companies. “Because of tight liquidity, it took a toll on the overall credit system owing to a surge in the cost of funding,” said Dinesh Rohira, CEO, 5nance.com. “The squeeze in liquidity system was followed by a downgrade in credit papers of troubled entities by rating agencies. As majority of debt mutual funds were holding entities such as ADAG stocks and Essel Group coupled with Yes Bank and DHFL, they saw substantial downgrade in debt papers within a short span of time,” said Rohira. “Funds have had to write off their entire investment in some of the entities [which have defaulted like IL&FS], while some funds have withheld redemption payments [in view of reschedule of repayments in case of Essel Group]. Additionally, credit rating downgrades have forced funds to revalue select investments downwards, which has also impacted returns from these funds,” said Dheeraj Singh, head of investments and fund manager, Taurusasset Management Co. Ltd.

Such events had spillover effects on the debt mutual funds adding to redemption pressure, speedy outflows and sluggish inflows. “To honour the redemption pressure, the funds have been liquidating their high quality securities. Therefore, the percentage of lower-rated papers has been continuously going up. Some of the fund houses such as BOI AXA have seen massive redemptions during this period and as a result the exposure to various entities has gone to disproportionate levels,” said Nath.

WHAT YOU SHOULD DO

Experts believe that the worst may be behind but you still need to remain cautious. “It’s very important that you keep your portfolio diversified and there is no concentration of issuers,” said Devang Shah, deputy head of fixed income, Axis Mutual Fund. New investors should be cautious while selecting debt funds. “Choose only those schemes which are not exposed to downgraded credit papers in portfolio,” said Rohira. You should also consider evaluating the portfolio in terms of credit quality. “Investors should continuously monitor portfolios of the funds they have invested in and look out for exposure to entities that may be in financial trouble or possibly be a likely candidate for a credit rating downgrade. Avoid exposure to such funds,” said Singh.

Exiting debt funds in a hurry may not be a good idea because you will take all the losses, especially in funds where there is a potential for write-backs, where you will miss potential NAV recovery due to write backs, added Nath. Specifically, you can avoid closeended mutual funds. “A major setback has already been seen in fixed maturity plans of debt funds which do not offer an exit option,” said Rohira. Side-pocketing allows AMCS to keep aside troubled entities separately to prevent the NAV of the portfolio from getting impacted and there is a chance that you get repaid once the money is recovered from the side-pocketed troubled entities.