Investors move away from high-risk fixed maturity debt funds

Overheated markets are a concern not just for equity investors, but for those investing in debt too.

Just as fund managers are increasing their allocations to mid- and small-cap stocks whose valuations are frothy, debt fund managers are stacking up lower-rated debt, which carry higher risk.

According to data from ACEMF, two-thirds of the 771 Fixed Maturity Plans (FMPs) had allocated their assets into relatively risky debt instruments, rated AA and below towards the end of June.

In value terms, 27 per cent of the ₹90,000-odd crore assets under management of FMPs, valued around ₹24,000 crore, were invested in ‘AA’ and below rated debt instruments.

This is way above the 10 per cent exposure to lower rated bonds in March 2014.

The good news is that investors are beginning to move away from these funds. While the assets under management (AUM) of all debt funds put together rose by 46 per cent in 2016-17 and inched up further over the last three months, the AUM of FMPs fell 3 per cent in 2016-17, and by a sharper 22 per cent over the past three months.

FMPs are closed-end mutual funds that you can invest in only during the new fund offer (NFO). As FMPs invest in debt instruments that have the same maturity as that of the fund, they are free from interest rate risk. But they carry credit risk, as there is a possibility of default by the debt-issuing company.

The funds’ increasing exposure to lower-rated debt, therefore, poses a threat to investors’ capital. The shift towards riskier assets is due to fund houses now launching FMPs with tenure of more than three years, longer than the earlier tenure of slightly over a year.

This change in strategy was brought about by the tweak in the 2014 Budget, which increased the tenure for debt funds to claim long-term capital gains, from one to three years.

Earlier, when FMPs had an investment horizon of around one year, they invested mostly in short-term debt instruments such as certificates of deposit (CDs) from banks, and commercial paper (CP) issued by companies.

Given the longer tenure, the funds have found it difficult to shop for good rates within the highest-rated instruments of longer tenure.

They have therefore increased investments in AA and below rated debt papers to increase their yield. Lower-rated papers carry higher coupon rates than higher-rated papers.

This hunt for higher yield is beginning to weigh on debt funds since instruments offering higher rates are mostly issued by corporates with stressed balance sheets. The probability of default is much higher in these companies.

Over the last three years, there have been many instances of debt funds taking it on the chin, owing to credit rating downgrades of the debt instruments they hold.

In mid-2015, two debt schemes from JP Morgan MF were hit when Amtek Auto bonds were downgraded.

More recently, in February 2017, four of Taurus debt schemes posted huge losses when the commercial paper issued by Ballarpur Industries was downgraded.

In May 2017, when ICRA downgraded the IDBI bonds, a few funds from ICICI Prudential, Baroda Pioneer, Birla Sunlife and Edelweiss Funds took a beating.

The problems of FMP managers have been compounded by falling returns on these low-rated bonds.

FMPs’ returns have slipped from 11-12 per cent in 2014 to 8-9 per cent. Given the lower returns, higher risk and the lack of a tax advantage, it is no surprise that investors are moving money out of these funds.