Debt direction

A smart selection of funds is key to debt fund investment, says  Nilanjan Dey

  • Published 23.05.16

The debt profile of India Inc does not appear very healthy right now. Fresh doubts are being raised about the quality of debt issuances by companies, thanks to a number of negative factors that investors can ill afford to ignore.

Rating downgrades have been on the rise lately, prompting the market to conclude that the credit quality of the corporate sector has taken a bigger-than-expected hit. Suddenly, debt is bad news for many.

A quick look at a few dominant trends will help underline the situation. Downgrades by rating agency Crisil in 2015-16 has increased to an all-time high of Rs 3.8 trillion, triggering uncertainty about the quality of debt in the country.

The metal and infrastructure sectors are particularly affected. While a sharp improvement is unlikely in the near term, a broad-based correction will depend on the pick-up in investment demand, a favourable monsoon and the government's ability to spearhead reforms.

The market is also keenly aware of the unfolding crisis stemming from non-performing assets (NPA) of banks.

Rising NPAs is the biggest threat faced by banks at present, making the overall picture look more grim.

Already, there have been sporadic cases of default, such as Amtek Auto. An increase in stressed debt implies higher risks for investors. Such risks arise when a borrower fails to make the stipulated payments. Interest payments and principal repayments are absolutely vital for the debt market.

Not insulated

Debt funds, which invest in various fixed-income securities, are not insulated from these trends. In fact, the portfolios they build can potentially include possible defaulters.

How, then, should investors look at such funds in the coming days? How should they choose superior products and stay away from the inferior ones? What sort of risks should investors be aware of? To answer these questions, let us consider some basic characteristics of debt funds.

Debt funds are somewhat predictable: A regular investor is likely to view these funds as fairly conventional tools. Returns delivered by similar types of funds will probably not vary too widely. The same seldom happens for equity funds. Liquid and short-term debt products, for instance, will generally yield parallel results.

Portfolio construction is a very precise exercise: A debt fund has a very well-defined objective and a select investment universe to draw its assets from. The fund manager's task is finely outlined.

Debt funds are subject to credit risk: Credit risk spirals when defaults happen. A big default by a portfolio constituent can have a serious impact on the fund. Interest rate risk is the other big worry.

Therefore, a debt fund may be seen particularly in the context of its basic objective, portfolio-construction strategy and credit quality.

In fact, the ratings allotted to its holdings must be analysed methodically - investors will develop a clear idea of its strengths and weaknesses if such an analysis can be done.

Know your needs

As serious investors are aware, the range of debt funds is quite varied. There are different categories of products to choose from - from ultra short-term to typical long-term income funds. Investors should choose funds that match their time horizon.

A liquid fund, for instance, will appeal to those who may have money to spare for just a few weeks. Expand the time horizon to, say, two years, and there will be different types of funds to explore.

If you want to keep your allocations locked in for specific periods, you can consider fixed maturity plans.

Such diversity and the convenience of purchasing open-ended funds actually add to their attractiveness. Indeed, with fixed deposits offering so little by way of yield, the popularity of actively-managed debt funds is on the rise. Fixed deposits, especially bank deposits, are the traditional adversaries here.

Remember, we are in a declining interest rate scenario. The latter is normally seen as positive for investors, thanks to the inverse relationship between prices of debt securities and interest rates.

The two move in the opposite direction - so when interest rates decline, prices of securities rise. Hence, investors manage to record gains in terms of rising NAVs.

The time is now

There is no time like the present. This may sound clichéd but let's view it in the context of the following pointers:

Determine your risk appetite first; choose the correct sort of debt funds next.

You can start with a lump sum allocation if you have the right resources. Follow it up with systematic investment plans.

Recurring inflow of income should be a dominant theme for your portfolio. This is not to suggest that you should ignore growth of capital.

It is important to diversify your debt holdings, especially if you are an aggressive debt fund investor.

However, in these uncertain times, do not expect superior performance from your fund managers every season. Your overall returns should beat the combined impact of taxes and inflation by a good measure. Otherwise, if you are a more conservative investor, a judicious combination of deposits and debt funds should lead to the ideal allocation.

The writer is director, Wishlist Capital Advisors