Real Returns. Can debt funds suffer losses?

Investors in debt funds received an unexpected jolt last week after two open end schemes — JP Morgan India Treasury Fund and JP Morgan India Short Term Income Fund — suffered sharp NAV losses on a single day and the fund house imposed restrictions on redeeming them.

The episode has triggered unease among debt fund investors and given rise to two key questions. How can debt funds suffer losses? If they can, are all debt funds prone to them?

Debt funds aren’t as risky as equity funds, but they can subject you to partial loss of capital if they make wrong credit or interest rate calls.

This is because, unlike bank fixed deposits, returns on debt mutual funds are market-linked. Debt funds invest in fixed income securities such as G-Secs, corporate bonds and money market instruments.

But their returns are determined by their Net Asset Values (NAVs). The NAVs of debt funds can register two-way movements, based on the behaviour of the bonds in their portfolio.

Having said this, there are three circumstances under which a debt fund can suffer value erosion. One, debt funds can lose value if interest rates in the economy rise. This is because, in a rising rate scenario, newer bonds offer better interest rates to buyers.

Therefore, investors promptly dump older instruments reducing their market value. Indian investors experienced this in July 2013. As the RBI sharply hiked its short-term rates to prop up the rupee, debt fund NAVs suffered losses of 3-4 per cent in a matter of weeks.

Two, a debt fund’s NAV can fall if a borrower delays or defaults on either its interest or principal payments. When a borrower slips up, a part of the fund’s portfolio becomes irrecoverable. Regulations require the fund to take write-offs to reflect this loss.

Three, a debt scheme’s NAV can also fall if a security held by it suffers a rating downgrade. When a bond is downgraded, investors perceive higher default risk associated with it and promptly mark down its value. It was the last factor, in fact, that triggered the 1-3 per cent NAV drop on the JP Morgan schemes last week.

What went wrong

Basically, two schemes from the fund house — JP Morgan Short Term Income Fund and JP Morgan India Treasury Fund — had invested in the Amtek Auto’s bonds to the extent of 15.3 per cent and 5.3 per cent respectively (as of end-July).

In August, rating agencies Brickworks and CARE, who had earlier rated Amtek Auto at A+ and AA- respectively, decided to revise their ratings after the company reported losses for the June quarter, sparking rumours of difficulty in servicing debt.

While the company insisted that it was in talks with lenders and had not defaulted, the rating agencies, citing financial stress, acted. CARE decided to suspend its rating and Brickworks slashed its rating on the bonds straight from A+ to C. This forced JP Morgan AMC to write down the value of Amtek Auto in its portfolio.

Had the schemes’ exposure to the bonds been at 2-3 per cent each, they would have suffered a mere blip in the NAV. But with the holdings as high as 15.3 and 5.3 per cent, the write down triggered a sharp slide.

So will investors in the two JP Morgan schemes lose all their money? No, but they may lose some of their money.

As of now, Amtek Auto has not yet defaulted on its debentures. The company is due to pay back its borrowings to the fund house in the last week of this month. If it makes the payments, the write-down in the fund can be reversed and investors can recoup their losses.

But if Amtek does default, investors in the two funds should brace for the entire Amtek Auto holdings to be written off.

This could entail a 5.3 per cent erosion in the value of JP Morgan Treasury Fund and a 15.3 per cent erosion in the value of the Short Term Fund. Both funds may take a long while to make up for these by way of returns.

In the interim though, if a large number of investors rush to redeem their units in these two schemes, the fund may be forced to sell its other holdings at distress prices.

This can dent the NAV as corporate bonds tend to be not very liquid. So, are all debt funds in the same boat?

No, but the episode does underline that, while seeking higher returns and tax efficiency from debt funds, investors should factor in both credit and rate risk. The debt fiasco at JP Morgan AMC was precipitated by quite a few unusual factors — a sudden slippage in Amtek Auto’s financials, knee-jerk reactions from rating agencies and the schemes’ concentrated exposures.

Under normal circumstances, companies seldom see a deterioration in their financials all of a sudden. Nor do rating agencies cut ratings overnight.

Short term debt funds too would usually avoid doubtful or illiquid paper. But both the Indian economy and the financial markets aren’t in a normal situation today.

A section of corporate India is grappling with high leverage. Global currency and bond markets are in turmoil.

Under these circumstances, you cannot avoid market risks while seeking higher returns from mutual funds.

So if you are completely averse to risk, bank deposits are your best bet.