The recent series of credit events in the debt market have made most advisors and investors shy away from most categories of debt funds. There is a clear shift from credit risk funds to corporate bond funds and banking PSU funds, which indicates that investors and advisors have taken a flight to safety.

However, these credit events have also changed the way advisors looked at debt funds. So far, most advisors have looked at one-year performance to pick up debt funds. However, this approach has changed and advisors have been looking at the long-term picture to select debt funds for their clients.

Apart from past performance, advisors should look at various parameters to pick debt funds. Let us look at these parameters one by one.

‘SEBI category’

The whole objective of SEBI’s scheme re-categorization was to create uniformity across strategies and offerings. When a fund is referred to by a name/category, it should communicate something meaningful about what the fund can do. Against this backdrop, you can decide which categories of funds you want to recommend to your clients based on their risk appetite.

AMC strategy

Within the SEBI norms, an AMC can draw up internal investment strategy to reduce risks. For example, in Banking PSU category, SEBI does not define the portfolio maturity range (i.e. minimum or maximum maturity) or the credit rating of the instruments. An AMC can define these investment norms in the investment objective clause of the Scheme Information Document (SID). For instance, while maximum exposure to instruments issued by one entity is capped at 10%, fund houses can internally set a lower limit to such instruments.

Going by these examples, if an AMC is pitching their banking PSU fund as a AAA oriented portfolio against another AMC with a mix of AAA, AA and A rated securities then you know which one has a better portfolio credit quality.

Portfolio credit quality

Credit quality is a function of two factors: category of instruments and credit rating. Talking about category of instruments, government securities are a better category than AAA rated PSUs and AAA rated PSUs are better than AAA rated private sector corporates. Similarly, in money market instruments, treasury bills are safer than bank CDs and A1+ rated bank CDs are better than A1+ rated NBFC CPs. Hence, higher the allocation to ‘better’ quality credit in the portfolio, the better.

Similarly, if we look at credit quality, you can see the fund’s exposure to various instruments depending on their credit ratings like AAA, AA and A.

While credit quality was always relevant, it has become more important in the recent times thanks to the series of defaults over last one year and ‘recency bias’ of investors.

Diversification

Post IL&FS default, we have witnessed that lower the bet on one entity, the safer it is. You have to look at how diversified the portfolio is: what is the exposure to the highest-allocated security, the top 5 and top 10 exposures.

Corpus stability

The underlying market of debt securities is not very liquid, particularly for securities rated less than AAA. Hence, funds having higher corpus size could come under redemption pressure.

Default track record

The track record of exposure to default papers in the category indicates how safe it is. Arguably, even credit risk funds are not as bad as it was a year and a half ago as yields were attractive and there were no stories of defaults. If you are looking at a safer bet then see the track record of the category over the last year or so.

Source: https://cafemutual.com/news/guestcolumn/408-how-to-select-debt-funds-in-the-current-eventful-times