Debt fund investors, beware. The credit quality of Indian companies has become a major concern for fund houses, which may eventually face a shortage of reliable debt securities. As the possibility of too much money chasing too few papers looms large, the risks for debt fund investors will increase.

The slipping credit quality will narrow down the universe of debt funds, which have lately attracted many investors because of various reasons. A section of them has moved towards debt — away from other asset classes, notably equity, which has remained volatile for fairly long. Debt funds have scored because of their consistency and reliability.

Be aware

In the emerging scenario, investors need to be aware of the risks — particularly, credit risk — which debt funds carry.

An issuer of a security (such as a debenture or a bond) is expected to meet all payment obligations. Credit risk occurs when such an issuer defaults on payment of interest or repayment of principal. Even when no default occurs, the price of a security may get modified if the credit rating of the issuer changes.

Debt funds’ exposure to corporate bonds is a moot point here. Within the world of bonds, there are various levels of security, denoted by credit ratings. Investors should appreciate the significance of well-rated papers in their portfolios.

The better rated papers tend to be less risky. For instance, AAA or P1+ rated instruments are comparatively more reliable than AA or P1 rated securities. Fund managers are often at a liberty to increase or pare their allocations to such instruments, depending on their strategies and investment objectives. In comparison, a government security is a safe bet because of its sovereign status.

Rate factor

The other major risk stems from interest rates. As everyone familiar with debt funds know, the price of a fixed-income instrument will normally decline when interest rates increase, and vice-versa. The nature of increase or decrease in prices depends on the coupon and maturity of the security. The net asset value (NAV) of a fund will change as a consequence. Thus, the NAV is expected to move up from a fall in interest rates, and it will decline when there is an increase in interest rates.

The universe of debt funds has to wrestle with several other risks as well. For instance, the liquidity of fixed-income securities may change as a result of certain market conditions. At the time of selling, a security can turn illiquid, resulting in loss in the value of the portfolio.

Mixed signals

The matter needs to be viewed in the backdrop of strong signals coming from key sources such as rating agencies. Crisil has, for instance, recently revealed that its credit ratio (that is, the ratio of rating upgrades to downgrades) stood at 0.87 times for the first six months of the current financial year.

Over 85 per cent of the downgrades occurred because of two reasons: a slowdown in demand and a stretch in liquidity. The latter is a result of delay in receivables. What is worrying is the agency’s belief that the credit quality of companies will stay weak over the near term — not a small problem, especially so in the context of high interest rates.

Clues gleaned from the banking sector are also clearly tell-tale. Non-performing assets of Indian banks are expected to increase, which, seen in a scenario marked by slowing demand, can indeed be a major worry.

So, what will sustain and drive the credit quality in the days ahead? The positive factors, I feel, will be mostly company-specific and not industry-specific. A select number of companies will be able to do better, which will be reflected in satisfactory debt-servicing measures.

Some corporates will be able to modify their capital configuration, either through additional equity or decrease in debt. In a few exceptional cases, the concerned sectors will gain from healthier business conditions. Typically, these sectors are not overly dependent on investment cycles.

Cautious approach

It is too early to suggest that Indian companies will soon throw up more defaults. But if it does happen, institutional investors (including asset management companies) will be faced with bigger questions concerning the creditworthiness of business entities.

The need for quality assets is already quite pronounced at this juncture. I must point out here that the chances of credit downgrades and defaults are rather high during an economic crisis. That such a crisis exists today is evident from many fundamental factors. There are a large number of leveraged companies (simply put, these are entities that finance their businesses with debt). Their presence compounds the problem.

In this situation, I will suggest a few options that debt fund investors should explore:

n Existing investors can modify their allocations to accommodate debt funds that are less risky. Opting for fixed maturity plans can be a good idea as their yields are quite predictable.

n A new investor should think twice before investing in funds that carry high exposure to such companies. Go ahead only if you have the appetite for the risk associated with these funds.

n Fresh allocations may be done in a graded manner, ideally through SIPs (systematic investment plans). You can select funds, amounts of investment and dates of entry according to your convenience.

n If you are still not comfortable, make at least a partial exit from funds and invest in fixed deposits. The latter will get you guaranteed returns.

Remember, debt funds indeed have lower risk compared to equity funds. But this is not the reason why you should disregard their risk altogether. All debt funds are market-linked, their yields are determined by fund managers’ skills. Returns are not guaranteed; not even capital preservation is assured.

You should always consult a professional financial advisor who can explain the risks, dispel the myths and guide your investments.

The author is director, Wishlist Capital Advisors