Be Alert !!! While Investing In DEBT MFs

Debt mutual funds, which were considered to be a safer investment, are rocked by some back to back bad events in the corporate sector. This has led investors to re-think on investing in debt mutual funds. DSIJ explains how to check this warning signal before investing in debt MFs.



It is very sad to find that debt mutual funds, which were considered to be a safe option when compared with equity mutual funds, are losing their coveted position. Thanks to some of the back-to-back events that have raised questions over the debt fund’s performance. After the last year’s IL&FS fiasco, recently the incidents of Essel and DHFL (Dewan Housing Finance Ltd.) defaulting on their payments resulted in downgrading of papers (debt instruments) issued by them by the rating agencies. The debt mutual funds having high exposure in their papers were adversely impacted.

The debt mutual funds that held debt securities of Essel and DHFL amounted to around Rs. 7,524 crore and Rs. 7,041 crore, respectively, at the end of December 2018. These papers formed around one per cent of the total debt AUM during the same period. Hence, the defaults may not destabilize the entire debt category. Still, the debt mutual fund retain its status of being one of the safest avenues of investment, but investors need to be cautious and carry their own due diligence before investing in debt mutual funds.

High Concentration In One Issuer

 If the debt mutual fund’s investment is tilted towards a single issuer, then that should raise an alarm. As such a fund is sitting on different instruments issued by the same company, there is a company-specific risk. Say, if the company starts running into losses and is not in a position to honour the payments, the mutual fund investing most of the assets in such a company could be at huge risk. Even one or two downgrades can have an overall impact on the fund's performance. Although no fund can hold more than 10 per cent of the total assets in securities of one company, anything more than 7 per cent of total assets can be considered as an alert. If you are a conservative investor, then get out of these funds and invest in other much safer funds. However, the aggressive and super-aggressive investor can hold such investments as returns can be expected to be much higher. If the investments are linked with financial goals, then even the aggressive investor must refrain from investing in such funds.

High Concentration In Low Rated Securities

To jack up their returns, debt mutual funds usually take the help of low-rated securities as these provide higher interest rates. Though nothing is wrong with it, debt mutual funds at times go heavy on investing in these securities, which makes the overall portfolio risky. The credit rating is one of the means through which one can gauge the probability of the borrower making timely payments of interest and principal amount. A low rated security means there are less chances of the borrower honouring the debt repayment obligation, while a highly rated security means the borrower is likely to honour debt repayment. Remember, the main objective of the investor in debt mutual funds must be to invest for safety of principal and not for returns. If return is your highest priority, then equity mutual funds will serve your purpose.

High Concentration In Companies Of Same Group

We had discussed earlier how it is not in your interest to invest in a debt mutual fund if the debt MF has a high exposure to a single company. The same way, even having high concentration in companies of the same group should also sound an alert. Investing in a debt fund having high exposure to companies of the same group makes the portfolio risky. This is because even some adverse development in respect of a subsidiary can harm the parent company as well, and vice versa. The group-level exposure in debt mutual funds, as per SEBI (Securities and Exchange Board of India), should not be more than 20 per cent, though this can be increased by 5 per cent with the approval of trustees. An exposure of more than 12 per cent of the total assets to the securities of companies from the same group can be considered as an alert. For the retail investors, it is not an easy task to verify as fund houses do not provide such information and, therefore, you cannot have a fair idea as there is a possibility that the names of the companies may not necessarily sound similar to that of the group.

Ratings Under Review

Investors usually are more inclined towards the credit ratings and changes in the same. However, investors should also look out for securities which are under review status by the credit rating agencies. This is the time when the credit rating agencies reassess the credit profiles of the securities and decide whether to upgrade, downgrade or maintain status quo. While doing the assessment, if the rating agencies find that the issuer is no longer in a sound position to honour the debt repayments, then they downgrade their ratings. Now, you may ask how that is going to help? With this information, you can check the recent developments that are happening with respect to that issuer. This will help you to gauge in advance what can be the outcome of the credit ratings which are under review. The thing to remember, however, is that the downgrade or upgrade is not just based on the issuer or the company, but also on the instruments and the tenure of that instrument. There is a possibility that due to huge loss in the short-term, the rating agencies may have downgraded the short-term instruments, but maintain status quo on the ratings of the long-term instruments. So, take a holistic view and not in isolation.

Drop In Share Price

Though this is not directly related to the credit quality of the company, every time a drop in share price does not mean poor credit quality. But, at times, this can give you a rough idea about the company. If the stock prices are falling due to the concerns over the company’s further survival, then the probability of default is high. Kingfisher Airlines and Sahara are some of the examples of such a situation. To earn high returns, even some debt mutual funds get into a companies with pledged shares wherein the promoters of the company pledge their shares against cash. In case such companies default the repayment of debt, then the debt mutual funds may sell-off those shares. But by the time they decide to sell-off the shares, prices may have already eroded substantially and these funds end up making losses. So, it is always wise to use stock prices as an indicator.