How to choose the right debt fund

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Debt mutual funds, often seen as a safe bet, have endured nearly two years of turmoil, beginning with IL&FS Group defaults in 2018. The novel coronavirus pandemic has only worsened investor woes after the Franklin Templeton Mutual Fund liquidated six credit risk schemes citing redemption pressures.

Yet the research arm of Crisil Ratings Ltd. said investments in debt mutual funds can pay off.

“Our debt fund credit profiling analysis reveals that in April 2020, 92% of mutual fund investments were in G-Secs, cash and cash equivalents, fixed bank deposits and the categories Top-rated AAA or A1+,” said Jiju Vidyadharan, Senior Director at Crisil Research. “With the exception of credit opportunities, mid-duration funds and dynamic duration funds, all other categories of debt had at least 85% exposure to these instruments,” he said in the Special Weekly Series. Bloomberg Quint. The Mutual Fund Fair.

This, according to Vidyadharan, implies that much of the money invested by mutual funds continues to be in safe assets.

Crisil views mutual funds as an investment vehicle capable of borrowing based on a person’s risk profile. “When embarking on an investment option in the debt fund category, it’s important that you understand the risks involved and then choose a category that best matches your risk profile,” Vidyadharan said.

“Overnight funds are more suitable for an investor who does not want to suffer a capital loss. That said, if you want to participate in the credit market, get a higher coupon, and be willing to take that extra risk, then credit opportunities or corporate debt fund duration products probably make sense.

For more, watch the full interview here:

Here are the edited excerpts from the interview:

Therefore, when embarking on an investment option in the debt fund category, it is important that you understand what types of risks are involved and then choose a category that best matches your risk profile. So if that’s not the case, the investor really doesn’t want any form of sensitivity to your return, you really want maximum security of capital when you’re considering investing in debt funds, then it’s clear that credit opportunities, corporate debt funds are not the ones for you, even golden. I mean, gilt carries no credit risk, but that said, there is significant interest rate risk that comes with gilt.

Overnight liquid funds, probably arbitrage, are the kind of categories that are most suitable for an investor who does not want to suffer a capital loss. That said, if you want to participate in credit markets, get a higher coupon, are willing to take that extra risk, then probably credit opportunities or even corporate debt fund duration products, etc., have sense. So I think this is the first important point when it comes to choosing a debt fund to invest in. That said, once you have decided on the category that you think would best suit your risk profile, your risk tolerance if I had to say, it also becomes important to choose the right fund. When it comes to choosing the right fund, it’s important to understand that not all funds in a particular category, even within the categorization standards set by SEBI, carry similar risks. So, we have seen in the past, funds that have been segmented on the basis of duration buckets, as SEBI has clarified, also carrying different forms of credit risk in their profiles. So, it becomes important for investors to also get into the nature of the portfolio held by the fund, to understand what type of rating profile is in terms of investments, the liquidity of the portfolio, which is also extremely important – do they hold a lot of concentrated exposures. Many of these things also come into play once you’ve chosen the category that best matches your risk tolerance.

If there are accelerated redemptions or if there are accelerated redemptions, if I had to say, a lot of people are coming in for redemption at the same time, it actually puts a lot of stress on the portfolio. The fund manager would have a cash component in order to meet the regular type of redemption requests that are being considered, that are being planned. If something is out of the ordinary, that clearly means exiting, selling the instrument, and then taking that impact that is there due to liquidity and posting it to NAV. Therefore, liquidity becomes an extremely important piece of data when it comes to valuing a debt fund.

If I were to just use some of the recent examples, I think post-Covid, we see the volumes haven’t really come out; secondary market volumes are still there for corporate bonds. The challenge we see is increased impact costs due to redemption pressures faced by fund houses and therefore a larger premium that must be paid due to the illiquidity associated with the obligation. So in this context, liquidity becomes extremely important.

If I were to look at mutual fund data, about 75% of the entire industry is liquid corporate bonds and I would actually say not just liquid corporate bonds but also sovereign bonds , i.e. G-Secs and cash equivalents and treasury bills, which are largely a kind of liquid space. So it’s a good thing to have if you were to look at it from a liquidity perspective. Again, those three categories we talked about – credit, dynamic debt, and modified or medium-duration debt funds – are where we saw a greater amount of illiquid in the portfolio. But we believe that liquidity is something that becomes extremely important and if I were to look at the three — credits, liquidity and concentration — those three work together. So, if you are managing an inferior portfolio, it is likely that in a difficult situation, redemptions will start to accumulate in the fund, which may lead to the need to liquidate. As a general rule, the more liquid the liquid, the fund ends up with the most illiquid, the weakest assets. This is something we continue to see, especially during difficult market situations, including the global financial crisis, even today as we see it.

The underlying logic being that you have to be diversified, you also have to take into account the realities on the ground in terms of how the markets are moving. So you need to be diversified when you are in lower credits. If it is an A-rated bond, then clearly you cannot have 10 bonds alone in your portfolio. You have to be as diverse as possible. Other group shows also come into play.

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