Are Debt Mutual Funds Safe Investments?

Are Debt Mutual Funds Safe Investments?

The winding down of six funds has definitely created a lot of anxiety among investors. They should now check their debt mutual funds in terms of quality and liquidity. If the fund is holding sufficient liquidity and the quality of papers it has invested in is of superior quality, it is better to remain invested.

The virus pandemic is taking its toll and Indian debt mutual funds are one of the victims. The first casualty is definitely the winding down of six debt funds by Franklin Templeton India. This unprecedented move has put many debt investors in a fix. They are now apprehensive that this may soon impact other funds and so the question is whether they should remain invested in debt funds. Is the closing down of this fund the beginning of the end of debt funds as a relatively safe investment? Our analysis shows that the impact will largely remain contained and is not likely to spread to other funds or fund houses. To fully grasp this we will have to go through the sequence of events that led to such a closure and why there is less chance of it being spreading.
 

Fast and Furious Growth
Debt funds were always considered as boring and lacklustre investments, especially by retail investors, who consider bank fixed deposit as a better option. Nonetheless, there was a paradigm shift post demonetisation. It changed the very nature of investments by individuals. They were compelled to deposit their savings in banks. This made the Indian banking system flush with cash, leading to a lower interest rate on fixed deposits. At the same time, the performance of physical assets such as gold and real estate were not as exciting. Mutual funds, therefore, became a natural gateway for investments.

They were inundated with flows. Both equity as well as debt funds saw huge inflows post demonetisation. In the quarter of December 2016 to March 2017, debt funds registered a growth of 50 per cent in the debt AUM. Nevertheless, on a yearly basis, the AUM of debt mutual funds increased by almost 39 per cent in FY17 against FY16. The AUM of the debt funds reached its peak before the IL&FS crisis that put a screeching halt to growth in debt mutual funds. From the high reached in the month of August 2018, the AUM of debt mutual fund is down by 11.5 per cent.

IL&FS Default: A Turning Point

The default of IL&FS in the month of September 2018 was a turning point for debt mutual funds. The growth rate of debt AUM dropped from a high of 50 per cent to a single digit. The cascading effect of the IL&FS crisis was felt in the entire NBFC sector. There was a squeeze in liquidity which was followed by a downgrade in credit papers of troubled entities such as ADAG stocks and the Essel Group coupled with Yes Bank and DHFL. This forced many of the funds to write off their investments in some of such entities. Besides, funds also re-valued select investments downwards. All this in a way helped the entire industry to emerge stronger and withstand the current situation arising out of the pandemic along with the sharp downturn in economic activity. Even the closing down of the Franklin Templeton India’s funds is more of a liquidity issue rather than a quality issue. 

Big Shift in AUM Mix
The industry has learned its lesson from its previous mistakes and is now on a solid footing. The AUM mix of the fund has shifted towards stronger borrowers between September 2018 and March 2020. 

Private non-banking financial companies, which remained vulnerable to any economic shocks, saw their share of funding by mutual funds dropping by 1,300 basis points and now forms 19 per cent of the total debt AUM compared to almost onethird at the end of March 2018. The share of strong borrowers such as PSU and G-Sec increased from 24 per cent to 40 per cent in the same duration. Besides the borrowers there is even a change in the type of instruments held by the fund houses. Earlier, their concentration was more in commercial papers.

Commercial papers (CPs) are the short-term debt instruments issued by companies to raise funds, generally for a time period up to one year. It is an unsecured money market instrument and doesn’t have any collateral against it. After the IL&FS crisis, there was a drop in the share of CPs in the overall industry AUMs from 39 per cent to 21 per cent. Fund managers took a conscious decision to shift their debt books away from the CPs. At the same time, the exposure to ‘cash and others’ and ‘G-Sec’ increased. The share of corporate debt also saw an increase in the same period.

Another major significant improvement was seen in rated papers held by the debt funds. Post IL&FS, the fund houses became more conservative and increased the share of highest rated papers in their books. The AUM of the debt funds registered an increase in the share of sovereign and AAA-rated funds in their books. Their share increased from 59 per cent at the end of September 2018 to 78 per cent at the end of FY20. These papers are safer than papers rated below AAA, which shows that the risk profile of the holdings of debt fund has improved. 

Debt Funds Look Safer

Based on the above analysis of the debt mutual funds, we see that there is a structural shift in the assets held by debt mutual funds. Best rated papers backed by strong companies or parentage are being preferred by the mutual funds. According to a report by Morgan Stanley, at the end of September 2018, debt mutual funds had invested one-fourth of their corpus in companies that were facing funding constraints. This has come down to 6 per cent now. In the same period, the share of investment in companies with strong parentage or companies having little funding constraints has increased to 83 per cent from 59 per cent.

It shows that the debt MFs have become more risk-aversive and are not chasing returns, instead focusing on quality of the instruments held by them. Even the current event is more of a liquidity issue instead of a quality issue that we saw in earlier cases such as Essel Group or DHFL. Moreover, the most vulnerable category – credit risk fund – forms only 5 per cent of the total debt mutual fund AUM. The fact that the RBI has come out with special liquidity facility for mutual funds to the tune of Rs 50,000 crore offers hope in the sense that we may not see closing or shutting down of any debt funds.

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