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Is debt fund credit risk exaggerated?

LiveMint logoLiveMint 10-07-2017 Kayezad E. Adajania

The Financial Stability Report of June 2017 highlighted the credit risks that mutual funds have been taking. Are these fears exaggerated or are the risks in control? Mint asked experts in the industry

Nilesh Shah, managing director, Kotak Mahindra AMC

Out of the total debt assets that mutual funds manage, just 0.10% are BBB-rated, 3.66% are in the A category and 1.46% are unrated. The rest lie in higher-rated scrips, including government securities. Non-banking finance companies, micro-finance companies and banks have much lower credit standards. Most funds have built their own credit research team to analyse credit, structure transactions with appropriate security and monitor credit. Many of the large non-performing assets troubling Indian banking system have not been able to raise debt or equity capital from mutual funds over last many years. Funds declare their portfolios transparently, so it has become easy for people to opine on credit without reading that they are secured by equity shares of a blue-chip company with more than adequate margin. Most lower and unrated papers are secured with appropriate security. In the current environment, mutual funds have increased their due diligence as well as monitoring. Although Amtek Auto and Ballarpur Industries defaulted to mutual funds in last 2 years, most mutual funds didn’t invest even in the equity of these companies, whereas some ended up taking unsecured debt exposure on them. In the Credit Accrual Space, taking credit risk is part of the mandate. Mutual funds...(can) mitigate risk but can’t eliminate it completely. Don’t judge Tendulkar on one inning where he got out on zero.

Ashish Shah, director, Wealth First Portfolio Managers Ltd

Debt funds have grown very fast and will become major part of the financial saving system in 5 years. However, while equity fund management has matured and got disciplined over the years, fixed income management has not, quite yet. It’s a ‘debt mutual fund’ not an absolute return or hedge fund.

If you hold debt funds for at least 3 years, it works out to be better than traditional fixed income instruments, thanks to the government’s preferential tax treatment to debt funds. Unfortunately, the mutual fund industry believes only that only higher return get more inflows as we are increasing investor expectations. There is a lack of supply of good quality debt paper in the market and that is why fund managers are exposed to credit risk because information in debt markets is well known to most participants; buyers and sellers. The mutual fund industry must educate investors to expect returns equivalent to inflation plus 2%. That’s all.

Further, if the smartest bankers and their battery of lawyers cannot solve the puzzle of Rs13 trillion non-performing assets, how will mutual funds swim these waters? What did we learn from Lehman Brothers crisis? What’s worse, the credit risks that mutual funds take do not translate to returns; that is another mystery. We should take these warnings about acidic portfolios seriously. Investments in AAA-rates tax free bonds are much better.

Jiju Vidyadharan, senior director, Funds & Fixed Income Business - CRISIL Research

Globally, duration and credit are two of the principal sources of return for fixed-income funds. In India, for long, we have seen alpha generation only through duration calls. In that context, it is good to note that we have credit funds emerging as a significant category now. Rise in their popularity suggests the search for higher yields amid the current scenario of low interest rates.

Apart from credit risk, investments in lower-rated papers is also exposed to liquidity risk. And the concentration risk increases with lower credits as the impact of any potential weakness in credit quality of a particular paper can expose the fund significantly if it has concentrated exposure. Typically, the higher risk is compensated with higher return. For instance, 5 year A-rated bonds, as per Crisil’s bond matrices yield about 200 bps over AAA-rated bonds of similar maturity. Investors considering these funds need to therefore take note of the risk adjusted return from these investments, and not just the returns. Fund houses have the responsibility to a) educate their investors about the embedded risks; and b) build capabilities to assess and monitor such risks.

External credit ratings are professional tools available for mutual funds to validate their internal assessments. However, not all ratings are equal and the performance of ratings and rating agencies should also be assessed.

Amit Tripathi, CIO – fixed income investments, Reliance Mutual Fund

Capital markets and non-banking finance companies have filled in some of the space vacated by banks, which has raised questions on potential asset quality issues if this is happening for weaker credit exposures. These concerns have magnified in light of few credit events in issuers where mutual funds have had exposure.

The ability of capital markets to price risk, and to segregate credit and interest rate risks addresses a lot of these questions.

Bottom-up research approach, strong focus on individual balance sheet and cash-flow dynamics allows mutual funds to identify structure and manage risks.

Management quality and other softer aspects are evaluated to ascertain the company’s ability to manage environment or cyclical risks. The regulatory framework and internal investment policies ensures adequate diversification.

We are in the business of predicting credit migration. The upgrade-to-downgrade ratio for mutual funds is much better than the overall rated universe. Most of the sub-AA credit exposures are in schemes mandated and positioned so. Investors can choose the basis of their appetite for risk (duration or credit). We need to continue the positioning discipline to avoid negative surprises. As we increase our presence in debt capital markets, the importance of research can’t be over emphasized.

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