Debt funds predominantly invest in fixed income securities such as bonds, corporate debentures, Government securities, and money market instruments with the objective to provide steady and regular income. Debt mutual funds are less riskier funds than equity funds.

Note that, less risk is not the same as “risk-free/safe…” Unfortunately, debt mutual funds were presumed to be safe and everyone burnt their fingers, right from the investors to fund houses while chasing higher yields.

[Read: Should Retail Investors Stay Away From Debt Mutual Funds Altogether?]

Debt funds carry credit risk and interest risk, which are crucial to look for when investing. Most investors ignored the credit risk effect.

It is considered a credit risk or default risk when a borrower is at risk of defaulting on repaying the interest or principal on the committed date.

Credit rating agencies like CRISIL, ICRA, CARE, etc. measure this credit risk factor by giving a credit rating to the issuer of the bond (corporate or government entity) on their ability to repay by assessing their overall financial health.

‘AAA’ rated bonds or debt security papers are the highest rated with the least risk; whereas ‘AA’ rated and below rated papers carry higher risk.

When credit risk increases, the expectation on return also goes up. If a specific debt fund claims to generate very high returns, the first thing one should check is the credit risk of the portfolio.

Government securities have the highest-rated papers compared to the corporate debt papers. Therefore, to earn high yields, investing in corporate debt papers that are low rated papers can help, but remember these carry high risk.

In the past, most of the Debt mutual funds had exposure to low rated papers which came to light after the IL&FS fiasco, followed by DHFL Reliance ADAG, Essar, etc. These incidents unearthed the huge risk investors’ wealth was exposed to, which led to the erosion of wealth for many investors.

When the coronavirus pandemic lockdown hit the sluggish economy, there was redemption pressure on mutual funds houses. Even the notable fund house had to take extreme measures because it faced illiquidity pressure and at risk of hurting investors’ sentiments.

Taking into consideration the scenario, the government asked fund houses to increase their portfolio allocation of some categories of debt mutual funds to government securities.

[Read: How the Capital Regulator is Proactively Ensuring That Debt Funds Remain Liquid]

Thus, the fund houses have increased the mutual fund holdings of G-Secs and PSU bonds as a proportion of their overall portfolio. It increased to 23.1 percent in April from 21.2 percent in February. It constituted only 17.2 percent of the holdings in August last year. Their exposure to solely G-Secs have increased to 8.6 percent in April compared to 5.2 percent August 2019.

Fund houses now hold G-Secs to the tune of Rs 116210 crore, a 52.1 percent surge in six months, as reported by the Monycontrol based on SEBI’s data.

Table 1: Increase in G-secs by debt funds

Asset type Jan-20 Feb-20 Mar-20 Apr-20 May-20
Government Securities 98903.3 113780.6 111533.0 116209.9 137605.2
Commercial paper (real estate, NBFC, and others) 307097.1 278624.6 225609.7 281693.8 311750.2
Bank Certificates of Deposit 159758.3 159844.3 133560.0 121832.9 104962.1
Treasury Bills 162346.8 137640.2 62169.0 81568.0 182165.5
CBLO 110375.3 108854.5 112336.5 111011.8 123152.5
Other Money Market Investments 29116.0 41245.6 40888.2 40868.4 55964.5
Corporate Debt(Including Floating Rate Bonds, NCDs and Others) 419466.0 432702.9 398439.1 364418.7 386755.7
PSU Bonds / Debt 208678.6 211704.5 198388.2 196617.8 203836.3
Asset backed securities 11442.2 11216.4 10462.3 10185.0 10996.8

Note: The values are in crores in rupees

There has been a huge dent in the mutual fund industry due to the credit defaults and ignoring the changing credit rating. In the pursuit of higher yields, holding on to the downgraded papers proved to be an unwise strategy.

However at the same time, investors need to understand that the ratings of any corporate debt scheme cannot be the same across, a downgraded paper can get a good rating if the credit quality improves, but that does not mean that you should invest in schemes with toxic papers.

[Read: Lessons Learnt from the Debt Fund Crisis]

Table 2: Top Fund houses having highest allocation to a particular rating baskets

AMC Rating Basket Market Value( Crore) Allocation (%)
May-20 Apr-20 Mar-20 May-20 Apr-20 Mar-20
HDFC MF AAA 61100.96 62161.16 61427.33 16.81 17.98 19.23
ICICI Pru MF AA / AA+ / AA- 30469.69 32869.54 37303.43 9.04 10.19 12.39
SBI MF A1 / A1+ / A1- 56773.81 59939.50 44528.60 15.24 16.71 14.05
IL&FS MF BBB / BBB+ / BBB- 274.73 274.73 210.34 22.55 22.31 17.14
Nippon India MF BB / BB+ / BB- 105.48 104.39 103.33 0.06 0.06 0.06
IL&FS MF B / B+ / B- 204.43 204.43 204.43 16.78 16.60 16.66
Aditya Birla SL MF C / C+ / C- 332.47 332.47 594.82 0.15 0.16 0.29
UTI MF D 313.51 313.51 314.23 0.23 0.24 0.27
Nippon India MF Unrated 597.95 620.34 781.10 0.33 0.35 0.47

Data as on June 17, 2020
(Source: ACE;MF)

From the data table above, we can see some of the debt mutual fund schemes have not stopped investing in below AA rated papers, however the exposure in terms of market cap is less.

The most important thing investors can do is to choose a scheme wisely based on the following parameters:

  • Your investment tenure,
  • Your risk profile,
  • Your financial circumstances
  • The fund house’s characteristics, that highlights investments systems and the process followed,
  • The experience of the fund manager,
  • Assess if the credit quality of the investments papers held is congruent with your risk profile
  • The maturity profile of the overall scheme,
  • Qualitative parameters like Sortino and Sharpe ratio,
  • The corpus and expense ratio of the scheme,
  • The interest rate cycle,
  • The performance of the scheme in various market cycles in terms of rolling returns.

However, do note that the past performance of the scheme is in no way indicative of the future performance of the scheme. So thoroughly analyse all aspects before investing.

Debt funds are suitable for low-to-moderate risk profile investors. These funds are ideal for short-term investment goals ranging from a few days to as many as two to three years more.

Based on where debt funds invest, such as overnight securities, money market instruments, corporate bonds, government securities, etc. and the average duration of the bonds in their portfolio, the funds are classified further as Liquid Funds, Short Duration Funds, etc.

In the current volatile and uncertain market conditions, only funds that own a minimum of 80% in the Government of India or PSU debt papers may be considered. Stay away from those having high exposure to private issuers.

At present, short-duration funds look attractive from the risk-return point of view. Therefore, opt for a pure Liquid Funds and/or an Overnight Fund that does not have exposure to private issuers.

Before investing in debt funds, understand the various risks involved and invest in schemes where the portfolio risk aligns with your risk appetite and financial objective.

[Read: Make Mindful Choices of Mutual Fund investments in Current times]

Lastly, while investing in debt funds prefer the safety of capital over returns.

Alternatively, if you prefer to keep your capital safe, opt for bank fixed deposits.

This article first appeared on PersonalFN here

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