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An owner’s manual for debt funds

Here’s a low-down on how risks, particularly credit risks, play out in debt funds

By Nimesh Shah
  • Published 15.07.19, 12:04 AM
  • Updated 15.07.19, 12:04 AM
  • 4 mins read
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To sum up, when investing into the credit risk category of debt funds, one should ensure that the portfolio is diversified across issuers and sectors and invests in a number of securities. (Shutterstock)

Before investing in any product, it is imperative to understand how market risks work in that particular product. When it comes to debt mutual funds, there are several misconceptions attached to the risk aspect. Here’s a low-down on how risks, particularly credit risks, play out in debt funds.

Duration and credit risks

When you invest in equities, any event that threatens the earnings or prospects of the company poses a fundamental risk to the stock price. In the case of bonds, there are primarily two types of fundamental risks to the price.

The first is interest rate risk, also known as duration risk. The longer the maturity period of the bond, the higher is its sensitivity to such interest rate movements. But the less understood risk in debt investing comes from credit risks. If the issuer of a bond (who is the borrower) delays or defaults on his interest or principal repayments, that can immediately rob a bond of its value. This is described as credit risk.

We need to note that debt markets don’t just react to actual increases in interest rates or defaults by bond issuers, but also to future expectations on these risks. If the market believes that rates will rise in future, it will mark down prices of long maturity bonds ahead of the event. Similarly, if the market perceives a higher risk of default by a borrower for some reason (say, a liquidity squeeze or deterioration in finances), it will mark down the price of the bond, even without an actual default taking place.

How credit calls work

From a credit risk perspective, the safest bonds in an economy are those issued by the central government. Bonds issued by state governments and public sector entities come next in the pecking order of safety. Bonds issued by companies, NBFCs and all other entities carry varying degrees of credit risk.

Now comes the credit rating agencies. These entities independently assess the repayment capacity of corporate bond issuers. They assess the financial statements, cash flows and repayment ability of the company to rate its bonds. In India, long-term bonds rated AAA, AA, A or BBB are considered investment grade, while those rated BB, B, C and D carry default risks in varying degrees.

When debt fund managers want to take credit calls, they typically buy corporate bonds with AA, A or BBB ratings. They may also, subject to regulatory limits, buy unrated bonds.

When credit calls go wrong

There are three circumstances in which a credit call may go wrong.

1) A company which has been performing well suffers an unexpected deterioration in its financial position due to a downturn in its business, new competitors or regulatory changes. In such cases, rating agencies usually take note of the changes and downgrade the bond’s rating by a notch or two. When such a downgrade happens but is within the investment grade, bond prices witness a fall in the market as investors now demand a higher yield to compensate for the risk.

2) In rare cases, a company-specific event or liquidity squeeze can prompt a highly rated company to suddenly default on interest or principal repayments. In such cases, an AAA or AA rated company can be subjected to a multi-notch downgrade straight to default grade. In such cases, not only does the market price of the bond suffer severe erosion, liquidity for it can dry up in the market as buyers shy away from default risks.

3) Due to an extraneous event, the market may attach a higher risk to the company or the sector as a whole. This too can send bond prices tumbling.

Impact on funds

If any of the above mentioned situations were to play out, the outcome would be a decline in the bond’s market price. However, the extent of decline depends on whether the bond has suffered a default, a rating downgrade or only a change in its risk perception.

Sebi regulations require debt mutual funds to use a ‘mark-to-market’ valuation for all the bonds in their portfolio with maturity of 60 days and above. This means that if the market price of a bond falls due to credit risks, the fund needs to immediately write down the value of that bond and factor it into its NAV.

In bonds that have suffered rating downgrades of a notch or two, the fund writes down part of the value of its holdings. Where there’s been a default, funds will usually need to write down the entire value of the holding.

Dealing with credit risks

So, can investors in debt mutual funds check for and protect themselves against credit risks? They sure can... by running three checks on the schemes they plan to invest in.

One, when investing in a credit fund, according to Sebi’s classification rules ‘Credit Risk’ funds are required to invest a minimum 65 per cent of their assets in corporate bonds below the top credit rating and thus carry high credit risks.

Two, check the rating profile of the fund’s portfolio. But one must also understand that credit rating is a matter of opinion. As is the case with opinions, there can be variation in ratings issued by different rating agencies.

Three, check out the degree of concentration in the scheme’s portfolio in terms of — Issuer, group or sector level. The higher the fund’s concentration in its individual corporate bond holdings, the higher is its vulnerability to credit risks. The way to avoid adverse impact on the fund is to ensure adequate diversification.

Side pocketing

Owing to the recent developments in the debt market where certain papers came under stress, Sebi has allowed mutual funds to segregate their holdings in stressed securities. This practice, known as side-pocketing, helps fund houses to isolate risky assets. Once segregated, a set of units will contain investments made in the troubled paper, while the other set of units will contain all other investments and cash holdings. In effect, this helps stabilise the net asset value of the scheme and the likely redemption by concerned investors.

To sum up, when investing into the credit risk category of debt funds, one should ensure that the portfolio is diversified across issuers and sectors and invests in a number of securities.

The writer is MD and CEO of ICICI Prudential Mutual Fund