After several credit events over the past 10 months, starting with what happened at IL&FS in September 2018, debt fund investors are naturally a concerned lot. They are at a loss on how to deal with credit risks associated with debt funds. There is help at hand.
Here, we discuss how you could minimize credit risks in your bond funds. Note, you can only minimize and not eliminate, as it is not possible to do away with credit risk, unless it is a Government Securities (g-secs) fund. Even in g-sec funds, while there is no credit risk, there is interest rate risk; i.e., they are subject to market volatility.
The least risky options
To start with, look at the portfolio credit quality in terms of the blue-chip exposure. This is not just about the AAA-rated exposure; at one point of time, IL&FS and DHFL too were rated
– Sovereign i.e. G-Secs and Treasury Bills
– State Government securities, known as SDLs
– Bank CDs(certificates of deposits) rated A1+
– PSU exposures rated AAA or A1+
– Cash equivalent, which is parked in CBLO (collateralised borrowing and lending obligation), now termed as TREPS.
We have not mentioned bank deposits here as a mutual fund is supposed to invest in the market and not in bank deposits. Otherwise, Bank FDs also may be counted as blue-chip. Some points to note:
– We have mentioned Bank CDs rated A1+ and not CPs (commercial papers) rated A1+, as CPs may be downgraded and if the issuing company faces a cash crunch, may even default. Banks are a vital cog in the economy and thereby enjoy a pre-eminent position. Mutual funds invest in either PSU banks or leading private sector banks under RBI scrutiny.
– PSUs rated AAA are better than private sector AAAs by virtue of the implied Government patronage. Though it is not an explicit Government guarantee (there are certain instruments with Government guarantee, but we are talking of the regular PSU bonds), the majority ownership of the Government puts a certain moral responsibility on the Government to service the debt. IL&FS is not a PSU as such, but its shares are owned by entities such as LIC and PSU banks.
– The cash component parked in CBLO are safe too, mainly because of the structure of the instrument. There are collaterals of G-Secs / T-Bills (treasury bills) and the counterparty in the transaction is Clearing Corporation of India (CCIL), and not just any member of the CCIL system.
To summarize this point, higher the component of top-notch instruments, better is the credit quality of the portfolio. After having assessed the credit quality of the portfolio in the above manner, look at the AAA component, including private sector companies, and the business groups these companies belong to.
The next important factor to consider is the diversification of the portfolio. The more diversified the portfolio, the better. There is a fundamental difference between diversification in an equity fund and a debt scheme. In an equity fund the objective is to benefit from price up-tick and if the portfolio is too diversified and the price of the stock goes up, it would not really benefit the portfolio. In a debt fund, it is about taking the accrual and diversifying the credit risk.
One Liquid Fund had 10 per cent exposure to IL&FS and took a massive hit, wiping off more than one year’s return. Another Liquid Fund had just 2 per cent exposure and its NAV dipped only mildly. After the IL&FS default, we know nothing is sacrosanct. Hence, the lower the exposure to any security/business group, the lower is the credit risk.
Fund size and pedigree
These parameters are difficult to quantify or gauge, but if there is a run on a fund, the better-quality liquid papers are sold first and the extent of the inferior securities in the portfolio increases as a result. In the latest bunch of credit events, one AMC faced massive redemptions in a short period of time, leading to higher proportionate exposure to DHFL as it could not be sold off. There was nothing wrong with the AMC or its fund management; it was just that they were unfortunate. You have to watch over your funds and if there is sudden redemption pressure and the corpus size is diminishing at a rapid pace, there may be a case for moving to relative safety. This is not a fundamental principle of investment, but is about being practical; there may be a run on a fund due to perception issues as well.
Another parameter being discussed is that AMCs that escaped unscathed in this round of credit accidents are better. This approach is correct, but it may also be a case of ‘benefit of doubt’. That is, the reason an AMC may not be having any of the troubled exposures could be due to the credit management process and analysis of risk, but there may be an element of luck as well.