In Debt Funds, Be Alert About The Warning Signs!

In Debt Funds, Be Alert About The Warning Signs!

With the fall in overall interest rate, we have seen a decline in rate of interest offered to various small saving schemes by the government. This will impact investors who depend on such schemes as part of their retirement plan or to meet certain financial goals.

It is indeed very unnerving to see that debt mutual funds, which are considered to be safe haven when compared with equity, have been surrounded by back-to-back negative events, thereby denting confidence in this asset class. It all started with the IL&FS fiasco which was followed by Essel Group and DHFL defaulting on payments and getting downgrades from the credit rating agencies. Then there was an issue with Vodafone Idea. All these adversely impacted the various fund houses and their debt funds. And now we have Franklin Templeton winding up its six debt mutual schemes.

It is rightly said that hard times teach valuable lessons! The Franklin Templeton saga has been a punishing lesson to investors. A couple of months ago, Franklin Templeton wound up six of its debt schemes alluding to severe redemption pressure and illiquidity in the bond markets amidst the ongoing corona virus crisis. While doing so, the fund house mentioned that this is the best possible way to safeguard the interest of existing investors. In fact, it recently recovered Rs 2,666 crore in its six wound up schemes.

Therefore, as and when the debt instruments held by those funds reach maturity, Franklin Templeton would be able to recover the dues. However, it is a long journey ahead. The table below highlights the maturity profile of the six closed funds from Franklin Templeton. It can be seen that all the dues are expected to clear not before 2025. Therefore, to avoid such a situation it is always better to review your portfolio quarterly.

Listed below are a few pointers that will help you to be forewarned about any trouble that may be brewing in the debt funds you own.

The YTM Factor

Many investors, especially the retail ones, generally seek higher returns while investing in debt funds. However, it is wise to be careful while chasing returns. Higher yield to maturity (YTM) may seem attractive but can be risky. Hence, check whether a fund’s YTM is more than the median or average YTM of the fund category. For example, if the median YTM of medium duration funds is at 5 per cent and the fund you are invested in carries YTM of 10 per cent, this is a warning sign that you should not ignore.

In such a situation, it is always better to review your fund and most importantly its credit profile. This is because funds with higher YTM might have undertaken higher credit risks to generate higher returns. However, it may be fine if the YTM of the fund is only 2-3 per cent away from its median. Yet, you should still review that fund. In the debt funds’ space, higher returns do not always mean better funds. Hence, as a first step to prevent getting into trouble, look beyond just the returns.

Portfolio Profile

The instrument that forms part of the portfolio of debt mutual funds defines the potential performance and risk of the funds. Hence, it is important to check the portfolio of a debt fund before investing in it. If you are already invested, you should review the portfolio quarterly to understand any major changes that may potentially affect the performance of a debt fund. Checking the constituents of the portfolio of the fund often lets you understand which instrument forms the part of top holdings and how many assets in percentage terms are dedicated towards that instrument. Further, it also lets you know what kind of instrument it is and what credit rating that instrument holds. This will help you to understand how concentrated the portfolio is. And concentration not only means higher allocation to a single instrument but also higher allocation to a single issuing company or a single group.

Say, for instance, there are five instruments of a single company with 4 per cent allocation to each. However, even if the allocation to individual instruments is less, the allocation to a single company becomes 20 per cent. Hence, if something goes wrong with that company, 20 per cent of the portfolio gets exposed to a damaging situation. Therefore, it is important to not just look at the concentration towards a single instrument but also towards a single company or group. Even negative cash holdings can prove to be a red flag. This suggests that there is possible leverage in the portfolio due to redemptions.

Credit Rating

Investors usually are more inclined towards actual credit ratings and changes in the same. However, investors must also look out for securities which are under ‘review’ status by the credit rating agencies. This is the time when credit rating agencies re-assess the credit profiles of the securities and decide whether to upgrade, downgrade or keep status quo. While undertaking such an assessment, the rating may be downgraded if the rating agencies find that the issuer is no longer in a good position to honour its debt repayments. How is this going to help? With this information you can check all the recent developments happening with respect to the issuer.

This will help you to gauge in advance what can be the outcome of the credit ratings that are under review. That said, the downgrade or upgrade is not of the issuer or company but of the instruments of the issuer or the company. Also, there is a possibility that due to a huge loss in the short-term, the rating agencies might have downgraded the short-term instruments. However, on long-term instruments they may still maintain a status quo. Therefore, do not take hasty decisions in isolation. Do check for a change in credit profile of the debt funds on a monthly basis.

Conclusion

The Franklin Templeton fiasco or even the major credit events that happened previously should be taken as a lesson and you should not ignore the red flags while investing in debt funds. As discussed above, do check the debt fund’s credit profile, its portfolio, portfolio concentration and YTM. Further, never make a mistake of judging a debt fund based on Sharpe ratio, Sortino ratio or such any such metric. This is because higher returns would often show you better ratios but that in no way means that the fund is good.

Typically, debt funds do not have diversified risk metrics that are used for equity-dedicated mutual funds. Hence, it is better to invest in debt funds by checking credit risk, interest rate risk and concentration risk. However, you can consider value at risk (VAR) as a risk metric that would help you understand downside probability. Even the size of assets under management (AUM) matters. The AUM size must not be at the very higher end and neither should be on the lower end. Also, loss of AUM can act as a red signal. If the AUM of the overall category is lost then its fine, but when the AUM of the category is not falling but that of fund is falling then there is room for doubt. Meanwhile, you should also check whether the fund has witnessed any abnormal redemption.

❝Risk is like fire: If controlled, it will help you; if uncontrolled, it will rise up and destroy you.❞

- Theodore Roosevelt

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