Debt Mutual Fund Schemes: All Kinds Of Risks Playing Out?

B.V.R.Venkatesh Bapu Director,
Value Invest Wealth Management (I) Pvt Ltd

The total corpus of mutual funds has increased due to the large inflows from non-corporate investors after demonetisation. The absolute growth between September 2016 and March 2019 is around 50.6%. The major chunk of the growth has come from equity corpus and non-corporate debt corpus. Both the segments registered 118% and 41% absolute growth.



The sudden surge in the mutual fund corpus and the NBFC crisis has led to both the regular and the not-so-regular risks in investments playing out concurrently.

Debt funds in India are sold by indicating the yield to maturity of the portfolio, minus the expenses. The actual return is generated, apart from interest accrual, by the capital gain or capital loss due to yield movement. Of late, the default by some of the debt papers, rating downgrading and large-scale redemption in a particular scheme all led to a steep fall in the NAVs of certain schemes from select fund houses, thereby substantially eroding the returns generated.

Understanding Risks

Regular Risks:

These are the usual known risks prevailing in a debt market, i.e. duration risk, credit risk and liquidity risk.

However, what investors are currently experiencing is more of credit risk. Currently, this type of risk has become a point of concern for only select few schemes in certain fund houses. In select cases, some of the structured products taking equity as collaterals have further added to the standalone default issues.

The rating and valuation risk which a debt paper faces is another element which is hurting the debt market sentiments. Many woke up to the fact that a debt paper rating can materially impact the valuation of the underlying instruments and consequently affect the return generated by the affected schemes. Just like volatility in the equity market is a fact of life, upgrades and downgrades too is a part and parcel of debt market functioning. Whenever the rating goes below investment grade, as per SEBI norms, there is a mark down of 75% on the NAV along with an extra mark down of 25% which is at the discretion of the AMC, depending upon the exposure to that instrument.

The valuation risk further gets compounded if the AMC fails to manage its streams of net inflow into a particular scheme. This is an important aspect because there are mutual fund schemes which may have large investments from corporate investors. In the event of a negative development, these corporates are likely to redeem their investments at one go, a development that can have a tangible effect on the NAV of a fund.

Mismatch of liquidity of schemes and liquidity of underlying instruments:

Large inflow into debt funds have led to investing in instruments which are not as liquid as the scheme. When borrowers use short term lending to fund their long term lending, any failure to roll over leads to severe liquidity crunch, ending up in solvency issues. In order to mitigate such liquidity related risks, SEBI has brought about Over Night funds.

How should the investors avoid such risks when the debt portfolio is built?

It is almost impossible to avoid all the risks. However, enough homework should be done before building the portfolio to minimise the impact of such risks which are going to be common in the coming period.

Ways to Manage Risks

The following factors should be considered to avoid the above mentioned risks:

1. Schemes with high credit quality like AAA and AA instruments. 

2. Schemes with well-traded instruments like banks and PSUs, which have better liquidity and rating changes are few.

3. Avoid LAS (Loan Against Shares)

4. Fund houses which can withstand sudden surge in redemption without impacting the quality of the portfolio.

5. Investors with an agenda of long-term capital gain should avoid schemes with large corporate investments.

6. Reasonable part should be invested in FMPs with AAA portfolio to avoid duration risk and corpus related issues.

7. Well-diversified portfolio of low to moderate duration with high credit quality schemes with large fund houses and large schemes which manage the above risks with the non-corporate investors in focus.

For more information contact : B.V.R.Venkatesh Bapu, Director, Value Invest Wealth Management (I) Pvt Ltd.  Email: vbvalinvest@gmail.com