Ignoring risks in debt Mutual Funds could be perilous

The default of IL&FS has opened a can of worms for the Non-Banking Financial Companies (NBFC) that too at a fragile time when the banks are still assessing their own non-performing assets (NPA).

The twin influence further drew the NBFCs into a negative spiral which impacted their borrowing abilities and made serious doubts about raising further capital.

As the events unraveled further, more players belonging to this sector were hit with defaults, though technical, but certainly hit the investors who are exposed to these firms either directly or indirectly.

Debt funds which invest in various debt securities that raise capital for such companies for an interest are now clouded. Non-convertible debentures (NCD) are instruments which are issued by a company to raise capital.

They could be either secured where they're backed up with the assets of the company or unsecured.

These features would thus define the credit ratings which are issued by independent agencies mostly depending upon the debt servicing capability and also the interest rate.

Most of the times, the interest rate is dependent upon the prevailing market rates, the tenure of the NCD and so at a higher or better rating it could command a premium.

While these instruments offer relatively higher interest rates than typical bank or corporate fixed deposits (FDs), the liquidity is what attracts most investors.

These NCDs are listed in the stock exchanges and are tradable providing for higher liquidity. The trading is higher for those with better rating and so gain higher liquidity.

The ratings, however, are subject to revisions regularly and any thus are either upgraded or downgraded depending upon the company's performance.

These instances create opportunities for trade as the bond prices fluctuate and hence the yields on these investments.

Debt mutual funds especially of those with accrued strategy i.e. interest income as the main component, employ NCDs to generate income for the investors.

The interest income from NCDs provides for a constant income while the arbitrage in the interest rates derive capital gains.

These are the two sources of capital appreciation for the capital invested in these funds. And for the constant income that is available due to the interest payments of the instruments held in these funds, they are also dubbed as fixed-income products.

But, with the current defaults and turmoil happening in the borrowers' market (NCDs), the nomenclature of "fixed-income" seems a misnomer.

What's aggravating the cause is the regulations that's governing these instruments and the MFs. The rating agencies downgrade the instrument to a default status i.e. "D" when an NCD defaults a payment.

Accordingly, the MF houses have to announce the revision in their portfolio. For instance, in recent days, DHFL fell behind on its interest payment of their NCDs of value over Rs 900 crore.

Despite their logic of citing the trust deed where they've a window of 7-days extension to clear the dues, the rating agencies went ahead to downgrade.

This has led to the marked down on the holdings to the extent of 75 per cent to 100 per cent for the funds where these instruments were held and thus eroding NAVs & their value.

And as promised, DHFL has cleared all interest payments within the 'grace period' and intimated the exchanges of the same. But this hasn't marked up or translated the eroded value to good for the funds holding these NCDs.

This because, the credit rating agencies have a 90-day window for them to revise the ratings despite the changed credentials. Of course, the option of 'side-pocketing' i.e. segregating the portfolio of the affected instruments could've been an option other than writing down the value to the extent of the exposure.

The side-pocket would have restrictions on withdrawal for investors making quick exits and further impacting the liquidity of the fund or making fresh investments to restrict risk takers gaining undue advantage in case of the repayments.

There were instances during this saga where some of the funds have recovered to their value in full or partial and some cases the investors lost money too.

What's intriguing is the way both the investors and advisors approach debt funds.

For some reason, we tend to assume debt funds to be devoid of risks and especially of these extreme cases of default where the possibility of the capital being lost for the entirety proportionate to the exposure.

In equity MF, the risk and volatility are an accepted norm while the approach to the debt MF is on contrary to be of safe and consistency.

This is also the very reason that we employ these products in risk mitigation but it's time we give a serious thought on our assumptions on these funds.

(The author is co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)