Investors in debt mutual funds have had it tough over the past 2-3 years. After a sudden jump in retail participation across debt funds between 2014 and 2017, thanks to attractive returns and huge flows post-demonetisation,the party ended abruptly after the IL&FS crisis broke out in September 2018.

Since then, there has been a string of defaults and downgrades in bonds issued by various companies — Essel Group, Altico Capital India, Reliance ADAG, Vodafone Idea and YES Bank, to name a few — that impacted returns of debt funds significantly.

Franklin Templeton winding up six of its debt funds recently served a big blow to investor sentiment.

So, how safe are debt mutual funds?

A webinar, organised as part of the BusinessLine Knowledge Series, sought to clarify investor concerns over debt funds.

The panel included A Balasubramanian, MD and CEO, Aditya Birla Sun Life AMC, Ashish Shanker, Deputy Managing Director and Head of Investments at Motilal Oswal Private Wealth Management, and NS Venkatesh, Chief Executive, AMFI(Association of Mutual Funds in India).

Here are some key points of discussion.

What impacts returns of debt mutual funds?

The four components that drive the NAV of a debt fund are interest accrual (essentially the coupon payments on the bonds), monetary policy that determines the interest rate movement, defaults by the issuer of the underlying bonds in the portfolio and rating downgrades of bonds. If the interest rate falls, bond prices move up and vice versa.

If there are defaults or downgrades in the bonds of the debt fund portfolio, then NAV is marked down, impacting returns.

The NAV of debt funds fluctuate in the short term owing to these four events.

But over a long term the returns smoothen out.

Currently, there are 16 debt fund categories, according to SEBI’s categorisation. How does one pick the right category of funds?

Debt funds can essentially be categorised based on the interest-rate risk and credit risk in the funds. Of the 16 categories, funds such as overnight, liquid, ultra-short duration, low-duration, and money market funds, which invest in debt instruments of maturity up to one year, carry low interest-rate risk. Similarly on the credit risk front, funds such as corporate bond funds — that have the mandate of investing at least 80 per cent of their assets in AAA and AA+ rated debt papers — and banking and PSU debt funds — that invest at least 80 per cent in debt instruments of banks, public sector entities — carry lower credit risk. Other funds such as gilt funds, short- to long-duration bond funds, dynamic bond funds and credit-risk funds deliver higher returns by taking higher interest rate or credit risk.

Hence, conservative investors should stick with lower-risk funds. Those willing to take additional risk to earn higher returns can invest a portion of their debt fund portfolio in the fairly riskier funds (on duration or credit risk).

But is it possible for retail investors to assess the credit risk in the fund easily? Bonds of IL&FS were swiftly downgraded from top notch rating to ‘default’. Then there are complex instruments such as SPVs, credit enhancements, structured obligationswhich are difficult to comprehend.

Just as in the case of the banking sector, where NPAs shoot up in certain periods, in the mutual fund industry, too, there are phases when the downturn in the economy leads to several downgrades and defaults, in turn impacting returns on debt funds. IL&FS was a one-off event, but it snowballed into a liquidity crisis for the NBFC sector, that led to a series of credit events in the past two years. Hence, investors have been hit by the sudden defaults and downgrades of high-rated debt securities over the past two years.

Usually, complex instruments find place in the riskier category of funds.

But given the leeway in each fund category, sometimes, complex instruments such as credit enhancements, structured obligations, etc, may exist in the portfolio of funds that are meant to carry lower credit risk.

Hence, from the investor’s point of view, one should continue to assess the portfolio based on the credit ratings of the underlying bonds. If you are a conservative investor, pick funds with predominant exposure to high-quality debt papers (AAA rated). As in the case of some of Franklin debt funds, which were wound up recently, credit risk (high exposure to low-rated papers) can exist even in low-duration funds, which generally carry low interest rate risk. Therefore, check the fund’s portfolio for exposure to low-rated bonds.

Fund houses also disclose the type of instruments in the portfolio in their monthly factsheets that should help investors understand the portfolio better.

If investors are unable to gauge the risk of a debt fund, they can take help of financial advisors.

An important point to remember is that if a fund in a particular category is generating much higher returns than others, then it is likely that it is taking a considerable higher credit risk to earn the extra return.

Be wary of such funds and pick funds that commensurate to your risk appetite.

Owing to large redemptions, many funds have been forced to sell their good-quality debt papers. As a result, a few funds’ exposure to low-rated bonds and concentration in a single debt paper have shot up. What should investors stuck in these funds or other beaten-down funds do?

Given that the economy is facing serious challenges amid the pandemic crisis and that the headwinds will persist over the next one year, investors in such funds are in for a tough ride. Hence, investors should first re-assess their allocation to such funds.

If these funds are a notable 25-30 per cent of the investor’s overall debt portfolio, then one must reduce the risk by cutting down the exposure to these funds, despite the losses. This is because it is likely to take 18-24 months for the market for low-rated bonds to recover.

So, with the help of your financial advisor, reduce the exposure to such funds to under 10 per cent.

Going ahead, build a better debt fund portfolio that is well-diversified, based on your risk appetite. Limit exposure to riskier funds such as credit-risk funds to 10-15 per cent if you are averse to risk.

With interest rates falling, is this a good time to invest in long-duration gilt funds?

While interest rates are on the downtrend, thanks to the sharp cut in repo rate (by 115 bps so far) by the RBI, and the slew of liquidity measures announced by the central bank, the supply of government bonds could also remain high, with the Centre’s growing fiscal deficit.

Hence, returns can be volatile in long-duration gilt funds that carry higher interest-rate risk. Investors can instead can go for dynamic bond funds where the fund manager can actively manage the duration of the fund based on interest-rate movements. For a conservative investor with shorter time horizon, PSU banking and debt funds or corporate bond funds that carry high-quality debt papers and also cap interest-rate risk owing to their lower duration of 2-4 years, are ideal choices.