Take adequate care while investing in debt mutual funds

Most investors and advisors alike liquid funds to not just for their liquidity but also to their safety. This is because liquid funds invest in short-term market instruments like treasury bills (T-bills), government securities and call money that hold least amount of risk. The average maturity is mostly under a month to two months as the holding period of securities of these funds range below 91 days or of T-bills. 

Another variation of these funds is the ultra-short-term funds which hold a wide range of maturities from as short as few days to more than a year. Unlike the liquid funds, Sebi has not given any overt guidelines for this category of funds. So, the very reason for investor to invest in these funds is firstly, to get better returns (beat the inflation) and ensure the capital is safe at a lower cost.

While investing in equity funds investors are braced up both in mind and in reality for downside risks, as they understand the purpose of the investment and the nature of the instruments are borne by risk. Investing in debt funds is completely a different ball game as the very reason for exploring a debt fund is first on the safety part and secondly, it’s for better returns. 

Investors though could be disappointed with lesser returns, wouldn’t want to compromise the safety or capital erosion in these funds. Of course, this could happen with the long-term debt schemes where the long-term government securities would fluctuate due to the interest rate changes, macro-economic factors and government policies.

This is the case with the debt funds with accruals as the nature where the expectation of the investor is also completely different and assumes that the fund returns wouldn’t be less than a threshold (general market or bank fixed deposits) and are immune to interest rate variations. 

When investors get short-changed on these funds, then it’s not just the loss for the investors but also for the industry as whole which dents the confidence on not just these types of funds but on the overall mutual fund industry.

The source for return in any of these funds is the kind of securities they hold and by having a higher riskier security, the fund possibly could generate higher alpha (returns) but could we expose the capital to market vagaries thus putting the overall fund in jeopardy.

These securities are selected depending upon a combination of the primary research conducted by the fund houses and the rating provided by the agencies (rating). 

So, last week a steep downgrade of IL&FS and some of its subsidiaries by three rating agencies has led to erosion of net asset value (NAV) of funds which were exposed to these securities. 

About Rs 175 crore of IL&FS group’s Commercial Paper (CP) are held by various mutual funds that were to mature now. Regardless of the outcome of this whole episode, it serves a great lesson for the MF industry, the regulator (Sebi) and investors alike.

This also puts a spotlight on the credit rating agencies on how could a security be downgraded from A1+ to A4 overnight, bringing it to on the verge of a default? If the fund houses’ oversight is ignored, the fallout is upon the credibility of the rating agencies, though the role of fund house is under lens.

This is because of the actions by some of the fund houses makes us believe that warnings were disregarded for higher yield and hence exposing the investor’s money at higher than the desired risk.

Unfortunately, in the recent years there are similar cases during the JSPL saga, Ballarpur and Amtek Auto. Seems like neither the MF industry nor the regulator hasn’t learnt much from these fiascos.

The other part of the story is what happens to these exposures in that fund once they turn junk, how does it impact the fund, who values them and how’re they valued? These’re pertinent questions with no answers in sight! 

So, investors should beware and do a bit of further investigation even while investing in these otherwise considered innocuous funds. One should look for the concentration risk in these funds i.e. the instruments exposed to a particular company in various forms i.e. CP, bond, etc. Please be aware that Sebi has not specified any such instructions while exposure to a certain corporate in terms of its amount of securities. (The author is co-founder of “Wealocity”, a wealth management firm and could be reached at knk@wealocity.com)