Debt mutual funds, often considered as a safe bet, have witnessed nearly two years of turmoil, starting with defaults at IL&FS Group in 2018. The new coronavirus pandemic only added to investors’ woes after Franklin Templeton Mutual Fund wound up six credit risk schemes citing redemption pressures.
Still, the research arm of Crisil Ratings Ltd. said investments into debt mutual funds can pay off.
“Our analysis on the credit profiling of debt funds reveals that as of April 2020, 92% of investments in mutual funds were in G-Secs, cash and cash equivalents, bank fixed deposits and the top-rated AAA or A1+ categories,” said Jiju Vidyadharan, senior director at Crisil Research. “Barring credit opportunities, medium duration and dynamic duration funds, all other debt categories had exposure of at least 85% to these instruments,” he said on BloombergQuint’s special weekly series The Mutual Fund Show.
That, according to Vidyadharan, implies a large part of the money invested by mutual funds continues to be in safe assets.
Crisil considers mutual funds to be an able debt investment vehicle based on a person’s risk profile. “When you are getting into an investment option within the debt fund category, it is important for you to understand what are the risks involved and then pick a category that best addresses your risk profile,” Vidyadharan said.
“Overnight funds are better suited for an investor who doesn’t want to take a capital loss. Having said that, if you want to participate in credit market, get a higher coupon, and are willing to take that incremental amount of risk, then probably credit opportunities or corporate debt funds duration products make sense.”
Here are the edited excerpts from the interview:
I presume the central premise of your note is that while debt may have gotten its share of bad repute, it certainly still remains a very attractive investment proposition if done right?
Vidyadharan: Absolutely. So, a lot has been spoken about the need to really look at asset allocation, and I think you can never undermine the importance of debt when it comes to getting your allocation right. We’ve looked at the different categories of debt funds and over the last two years I think debt has been in the news possibly for all the wrong reasons. So, there have been downgrades that have happened on the fixed income side, there have been defaults, and mutual funds which have really been the more active players on the fixed income side, they have also seen their bit of challenges be it in terms of exposures to a lot of these papers that have seen downgrades, or even for that matter, defaults. However, and of course in recent times, the investor sentiments have only been dampened further because of all of the concerns regarding corporates. If you were to look at it from the current Covid environment, and even for that matter, some of the recent fund closures with a particular mutual fund — what that has all resulted in is quite a bit of money really flowing out of fixed income. If you were to look at the March 10 data, the extent of flows out of mutual funds was actually quite close, just a little lesser than what was the sort of flows that we saw going out of mutual funds, immediately after the IL&FS crisis. And unlike then, what we really see now is that then it was largely liquid funds where the money flew out. At this point of time, we saw outflows from various categories. Subsequently April, of course there’s some bit of money that has flowed back in, but we clearly see risk aversion as being a constant theme across investors. So a lot of money that has subsequently come back has flown into liquid, gilt, overnight funds, some of the corporate debt funds—the ones that are which are relatively safer in terms of the allocation that they have. Having said that, we’ve done a fairly interesting study, where we have looked at the underlying investments into the different categories of mutual funds.
Across industry, barring three specific categories — credit opportunities, medium duration debt funds and the dynamic debt funds — all other debt categories have had an exposure of at least 85% or more to safer investment options, including government securities, treasury bills, the highest rated corporate bonds or cash on cash equivalents. That’s one interesting trend we see.
What does that imply though?
Vidyadharan: That implies that a large part of money which is really invested by mutual funds today, continues to be in safe assets. Having said that, these three categories that I spoke about where there are exceptions, where credit opportunities is one category in which really stands out as being the one which had far lesser exposure to the higher rated components. So, all of these three categories are also incidentally the ones which have seen the maximum redemptions. So that clearly shows that at least when it comes to exits, most of the exits have happened in categories where the overall risk profile was not quite completely safe, if you were to look at it purely from a credit safety perspective. So, the key point therefore is that there’s this significant amount of money which continues to be in sovereign highest rated bonds and cash-on-cash equivalents which actually also highlights the fact that not all is really bad when it comes to mutual funds or debt mutual funds.
For anybody who is a retail investor, who has an adviser or doesn’t have an adviser, how does he go about picking the right kind of debt fund? What should he look out for?
Vidyadharan: I think it’s all a factor of risk tolerance and having said that, I think a lot has been spoken about credit opportunities funds in recent times and a lot has actually moved out of credit opportunities funds as well. I think if you were to look at it, it was targeted towards a specific class of investor who was willing to take that level of risk and who would have been cognizant of taking that risk for whatever is the additional return that has to be made.
It’s extremely important for retail investors to understand and appreciate that fixed income does not really mean fixed return, which is a big misconception when it comes to investing into debt funds. Fixed income funds carry various forms of risk, including risk of capital loss as well as risk of illiquidity and so on.
Therefore, when you are getting into an investment option within the debt fund category, it is important for you to understand what are the sort of risks that are involved and then pick a category which best addresses your risk profile. So if not the investor does not really want any form of sensitivity to your return, you really want capital safety to be optimal when you’re looking at investing into debt funds then clearly credit opportunities, corporate debt funds are not the ones that are for you, even gilt. I mean, gilt does not carry any credit risk but having said that, there’s a significant amount of interest rate risk which comes with gilt.
Liquid, overnight funds, probably arbitrage are the sort of categories that are better suited for an investor who doesn’t want to take a capital loss. Having said that, if you want to participate in credit markets, get a higher coupon, are willing to take that incremental amount of risk, then probably credit opportunities or even for that matter corporate debt funds duration products, etc., make sense. So I think that’s the first important point when it comes to choosing a debt fund to invest into. Having said that, once you have decided the category that you believe would best address your risk profile, your risk tolerance if I were to put it, it also then becomes important to choose the right fund. When it comes to choosing the right fund, it is important to understand that not all funds within a particular category even within the SEBI-defined categorisation norms carry similar risks. So, we have seen in the past, funds which have been segmented on the basis of duration buckets, as was specified by SEBI, also carrying different forms of credit risk in their profiles. So, it becomes important for investors to also then get into what is the nature of the portfolio that the fund is holding, understand what is the sort of rating profile in terms of the investments, how liquid the portfolio is which is also extremely important — are they holding a lot of concentrated exposures. A lot of these things also come into play once you have chosen the category that best suits your risk tolerance.
One of the things that you’ve said is credit profiling. Can you tell us what do you mean by this and how does a lay investor do this? What are the sources from which he or she can get some sense of the credit profiling of the fund?
Vidyadharan: So there are two things I think which are important. So one is the credit rating and that is readily available in the fact sheets which are disclosed by the mutual funds on a monthly basis as a part of their portfolio disclosures. Now, if you were to look at the fact sheets, the fact sheets would also give you what is the underlying holding that the mutual fund has in its portfolio and the outstanding ratings for those exposures that are a part of the fund’s portfolio. Clearly, a higher rating means that there is a lesser likelihood of default versus a lower rating. So that is one important point that you can look at — what is the extent of investments that the fund has to sovereign instruments, to AAA-rated corporate bonds, to even plus-rated corporate bonds.
The second additional input that can be looked at is the outlook. So, all rating agencies also publish an outlook in terms of the rating that they have outstanding. A negative outlook, and if you have a fund which has a higher exposure to negative outlooks which indicate that there is a likelihood that the rating may actually transit downwards, that’s again something that you need to watch out for.
A lot of the information is actually available in the fact sheets and it is only a matter of the investor actually going through it, understanding what is the rating-wise mix that the fund has in terms of its portfolio and then seeing how much is in more sensitive exposures, if you were to look at it from a credit rating perspective.
Are there some red signals or warning signs or flash signs that you would advise or you’d be able to tell that people should watch out for when they’re trying to do the credit profiling of the fund and the holdings?
Vidyadharan: So, I would actually say that when you’re looking at credit profiling, it is important to look at the rating mix. I think it is also important to look at the outlooks. Now, rating releases are available, so you can go through and see what are the holdings that mutual funds have at a group level, group exposure, whether it is concentrated group exposure, whether there’s a larger amount of structured instruments that are a part of the portfolio and so on. These are additional points that they could look out for, besides looking at the rating profile.
Another one is of course liquidity profiling. What are the telltale signs of there being some issues or what liquidity profiling can tell an investor when he’s trying to judge the book by the cover, if you will?
Vidyadharan: Indian fixed income markets is largely an illiquid sort of market where most of the fixed income instruments rarely come to trade, barring the benchmark issuers and so on. Having said that, there are some issuers which may be closely held, but which in a difficult situation can actually get traded simply because of the fact that there are people who are willing to buy that paper, it is only on account of lack of sellers that you don’t really see volumes for those papers. So, barring these, it is largely an illiquid market that we have on the fixed income side, especially on the corporate bond side.
I think the relevance of liquidity comes primarily because a larger part of the AUM today is in open-ended debt funds. And typically, with open-ended debt funds, these are daily liquidity products, if you get a redemption request you need to liquidate whatever is the asset and then make a good payout to the investor who has redeemed this holdings.
If there are expedited redemptions or if there are accelerated redemptions, if I were to put it, a lot of people are coming to redeem at the same time, it actually puts a lot of stress on the portfolio. The fund manager would have some cash component in order to meet regular sort of redemption requests which are envisaged, which are planned for. If anything comes in outside of the ordinary then it clearly means that he has to go out, sell the instrument and then take that impact that is there on account of the liquidity and post it onto the NAV. Therefore, liquidity becomes an extremely important element data when it comes to evaluating a debt fund.
If I were to just use some of the recent examples, I think post-Covid, we see that volumes have not really gone out; secondary market volumes continue to be there for corporate bonds. The challenge that we see is heightened impact costs because of the redemption pressure fund houses are facing and therefore, a larger premium that needs to be paid on account of the illiquidity that is associated with the bond. So in that context, liquidity becomes extremely important.
If I were to look at data on mutual funds, about 75% of the overall industry is in liquid corporate bonds and I would actually say not just liquid corporate bonds but also sovereigns, which is G-Sec and cash-on-cash equivalents and treasury bonds, which are largely a liquid sort of a space. So that’s one good thing to have if you were to look at it from a liquidity perspective. Again, those three categories that we spoke about — credit, dynamic debt and modified or medium-duration debt funds — are the ones where we have seen a larger amount of illiquids sitting as part of the portfolio. But we believe that liquidity is something which becomes extremely important and if I were to look at all three — credits, liquidity and concentration — these three work together. So, if you are running a weaker quality portfolio, there is a likelihood that in a difficult situation redemptions may actually start building up in the fund, which can lead to the need to liquidate. Typically, the more liquid is what gets liquidated and the fund then is left with whatever is more illiquid, the weaker assets. That is something which we keep seeing, especially during difficult market situations including the global financial crisis even today as we see.
How would any investor know whether the paper in the debt portfolio of a fund is liquid enough or not?
Vidyadharan: I would say it’s not very easy largely because it’s an illiquid market. The way we do it at Crisil, is we of course look for volumes, the information that is available on the exchanges. But as I said, not everything gets traded. So the next important element that comes is to really see what are the levels at which these papers are getting quoted in the market or getting issued in the market. So if they are getting quoted or issued at levels which are very close to what you typically see of the more liquid issuers, then these papers are liquid. Otherwise, there is this illiquidity component that is getting factored in to the pricing. So,it’s really a two-pronged process — volumes are readily available and accessible and second part is not so easily available, you really need to do some math to arrive at that.
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Would all of this analysis help an ordinary investor to safeguard himself against say an episode like Franklin? I’m not saying that the money is lost there, but all I’m trying to say is that if somebody wanted his investment to simply be a pass-through and the fact that it is not a pass-through. Would an analysis like this help safeguard against such an event?
Vidyadharan: I would think so. In fact and you’d be aware we’ve been putting out the rankings on mutual funds for a fairly long period of time now. In fact, we complete two decades this year of the rankings and you would note that we look at both performance as well as portfolio-based attributes. So, a lot of these things in which we covered as part of this report are also considered in the rankings. Rankings are readily available in the public domain so investors can actually go through the rankings, take a look at the funds and you will see that not a single fund where we have seen instances which were of challenging nature to investors have really been on the top in terms of the ranking. The fact that portfolio analysis is an important element really helps significantly.
The third one is the diversification profile. Are there some key benchmarks that people should keep in mind? Is there a base percentile that you believe should be there in every fund and which an investor can look at and figure out that whether this fund is heavily concentrated in one or two groups or is it diversified enough? What benchmarks or what parameters have you set here?
Vidyadharan: Again going back to the rankings, where we also look at concentration. We have looked at defining the limits which are aligned with rating categories.
For a AAA-rated instrument, I would go with a 10% being the sort of limit that can be looked at for ensuring that there is adequate diversification. In case of a AA, I think we have a score which is about 7.5% and the number comes down even further when it is A.
The underlying logic being that you need to be diversified, you also need to factor in the ground realities in terms of the way the markets are. So, you need to be diversified when you’re in weaker credits. If it is an A-rated bond, clearly you cannot have 10 bonds alone in your portfolio. You need to be as diversified as possible. The other group exposures also come into play.
And what would those numbers be according to you? Would it be up to a particular percentage that the fund should have exposure to a particular group? Is there a SEBI-defined limit for this as well?
Vidyadharan: There isn’t. What we note is that there are challenges in terms of this. One thing that is important is how do you classify a group? That’s one area where, I think, there is still some inconsistency but we look at it more as a hygiene factor in our rankings. We don’t really get into quantifying what is the sort of right limit for group exposures.
If a retail investor wants to take a slightly higher risk and not be in a complete liquid fund, then the number of checks and balances that he or she has to put out are very large. Now some of this might be readily available, some might be with the adviser, etc. What is it that an investor should completely avoid?
Vidyadharan: I think the need for funds to be true to label is also important. Does the fund really do what it states it is going to do? So I think that’s also equally important. Not again a very easy metric to really assess as individuals, but that I believe is an important factor and that’s clearly one additional learning that if you were to look at a lot of the episodes as well.
Is it possible to even predict that the worst of the issues are behind us or they might still be there, simply because of the problems around asset quality for banks, GDP slowdown and defaults might be very large. Is it actually even more important to be more cautious and more prudent while investing at the current point of time than the last few years?
Vidyadharan: Absolutely, I totally agree. You really need to keep your eyes open.
So you do believe that the next nine to 12 months, we are kind of walking on a minefield and people need to be careful?
Vidyadharan: Exactly. If you were to look at let’s say what Crisil puts out as the modified credit ratio, which is in simple terms is the amount of debt downgraded to upgraded. For the first time, it has been below one for about 2.5 years now. And the outlook is that it’s going to continue being there. So, you will see this to be a sort of a stressful period and in that context the overall portfolio assessment, evaluation becomes extremely relevant for investing.
