During the Union Budget 2021 speech, Finance Minister Ms Nirmala Sitharaman announced a proposal to set up a permanent institutional framework to enhance corporate bond liquidity during times of stress and to, generally, enhance liquidity in the secondary market. The proposed institution will purchase investment-grade debt securities both in stressed and normal times and facilitate development of the bond market.

You may be aware of the severe liquidity crunch that bond markets faced (especially in moderate and low-quality securities) due to the rising risk-aversion amid the uncertainty relating to the COVID-19 pandemic. Since mutual funds are one of the major active players in the corporate bond segment, they were among the worst hit.

The liquidity crisis in the bond market forced Franklin Templeton mutual fund to wind up six of its debt schemes, leaving its investors in a lurch.

It raised fears that few other debt schemes could meet a similar fate since many schemes across categories held significant allocation to moderate and lower rated debt instruments. Though holding exposure to low and moderate rated securities helps the schemes generate higher returns, at the same time it makes them prone to credit risk.

Fortunately, the debt market conditions improved as the government gradually lifted lockdown restrictions while RBI took steps to infuse liquidity and support economic growth. SEBI too initiated various measures to enhance the safety and transparency of debt funds.

However, there are still concerns whether debt funds have learnt from their mistakes and are prepared to face any adverse events in the foreseeable future.

Thus, we can see the creation of an institutional framework for corporate bonds as a positive development that can possibly instil confidence among the participants in the bond market by bringing liquidity in securities that may be at higher risk of being affected in times of stress.

Do note that the new institutional framework for stressed assets will be only for investment-grade securities, i.e. securities rated BBB- to AAA+.

Will the institutional framework make debt funds healthier?

In the aftermath of the liquidity crisis, many debt mutual funds reduced exposure to lower-rated instruments and the exposure to highly liquid AAA-rated instruments and G-secs was increased.

However, schemes in certain categories like Credit Risk Funds, Dynamic Bond Fund, Floating Rate Fund, and Medium Duration Fund still carry significant allocation to moderate and low rated assets.

Even assets of shorter horizon categories like Ultra Short Duration, Short Duration, and Low Duration Funds have significant exposure in moderate rated assets, along with predominant allocation to instruments issued by top-rated private issuers.

As of December 2020, debt mutual funds held around 32.7% of its assets in corporate debt of which a major chunk is invested in securities rated AA & below.

Table: Rating Allocation of Debt Funds across categories

Category % of category AUM
G-secs AAA & Equiv AA & Below BBB & Below D & Unrated Others Cash & Equiv
Banking and PSU Fund 12.91% 73.52% 6.21% 0.09% 7.28%
Corporate Bond 23.67% 67.82% 0.76% 0.00% 7.75%
Credit Risk Fund 6.00% 16.98% 59.91% 1.60% 2.72% 1.18% 11.60%
Dynamic Bond 50.99% 15.21% 17.74% 0.31% 0.41% 0.03% 15.30%
Floating Rate 28.42% 53.24% 9.76% 0.01% 8.57%
Gilt 88.75% 11.25%
Liquid 30.46% 46.38% 0.00% 23.15%
Long Duration 90.23% 3.42% 2.34% 4.02%
Low Duration 27.67% 52.71% 11.17% 0.02% 0.00% 0.00% 8.42%
Medium Duration 26.01% 23.90% 39.37% 0.55% 0.46% 0.09% 9.62%
Medium to Long Duration 44.33% 38.18% 6.70% 0.31% 0.17% 10.32%
Money Market 19.64% 82.93% 0.00% -2.57%
Overnight Fund 100.00%
Short Duration 31.44% 49.01% 10.69% 0.00% 0.00% 8.86%
Ultra Short Duration 21.12% 56.88% 12.41% 0.01% 0.00% 9.58%

Data as of December 2020
(Source: ACE MF)  

Once the new institution is created, it could benefit certain categories such as credit risk fund that have high exposure to low and moderate quality debt securities.

However, the details regarding the functioning of the institution is underway. It remains to be seen how it will be funded, the applicable conditions, etc. Moreover, it could be a while before the institution is set up and the expected benefits get reflected.

What should investors do?

Debt funds have witnessed various credit events in the past which led to erosion in the wealth of investors. It can take a long while for a scheme to fully recover from any setback caused by defaults and downgrades. So, when you invest in debt funds, focus on the safety of capital instead of chasing returns. Check if your debt fund manager is eyeing higher yields by exposing you to higher credit risk instruments issued by private issuers.

[Read: Lessons Learnt from the Debt Fund Crisis]

Avoid schemes (including short duration schemes) that have high exposure (over 20%) in instruments issued by private issuers, irrespective of ratings assigned by other rating agencies; it can expose the portfolio to credit risk. Even though fund managers have remarkably reduced their holding in low-rated securities in the aftermath of the Franklin Templeton crisis, many schemes across debt fund categories still carry significant allocation to moderate and low rated assets.

Notably, while the debt market situation has improved significantly post the pandemic-induced liquidity crisis and the market regulator SEBI has taken various steps to make debt fund investment safe, it still important to be cautious.

Therefore, to avoid taking any undue risk; invest in schemes that predominantly invest in instruments issued by government and public sector enterprises. These securities are generally high quality as the government-backing ensures enough liquidity and low credit risk.

Before investing in debt funds understand the various risks involved viz. credit risk, duration risk, interest-rate risk, liquidity risk, etc. and invest in schemes where the portfolio risk aligns with your own risk appetite and financial objective.

[Read: What Should Be Your Debt Mutual Fund Strategy in 2021?]

In addition pay attention to the following parameters:

  1. The portfolio characteristics of the debt schemes;
  2. The average maturity profile;
  3. The corpus & expense ratio of the scheme;
  4. The rolling returns;
  5. The risk ratios;
  6. The interest rate cycle;
  7. The investment processes & systems at the fund house

Alternatively, if you prefer to keep your capital safe, opt for bank fixed deposits. To ensure the most security, choose the bank carefully.

This article first appeared on PersonalFN here

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