There Is A New Dimension To The Risks In Debt Mutual Funds

The known risks in debt funds, inter alia, are interest rate risk (also known as duration risk, market risk or volatility risk) and credit risk (also known as default risk). What we will discuss is not so much of a new discovery in risk management, but something evolving in the current scenario of the debt market.

Let’s go over the basics first to get a perspective to the discussion. A mutual fund scheme can avail loans for meeting redemptions that can be up to 20% of the portfolio size. The loan may be either from a bank (bank lines or the special liquidity facility for MFs announced on 27 April 2020) or overnight borrowing on pledge of securities from the overnight borrowing-lending system called Triparty Repo System (TREPS). In a MF portfolio, there is a current assets (CA) or cash component, which usually comprises the cash equivalents in the portfolio. The cash component is not parked in a bank, but deployed in TREPS. This is usually on the lower side, say, less than 5% of the portfolio size, because the fund is supposed to deploy in securities as per mandate. On rare occasions, the cash component may show negative balance, say -2% of the portfolio size. This may happen due to a technical reason.

Here’s the current context. Since March, MFs are facing redemption pressure. To meet redemptions, normally MFs sell securities in the portfolio for liquidity. However, in March, the debt securities market was tight, traded volumes were low and yield levels were high or prices were low. In this situation, when selling a security would mean incurring losses, some MFs availed of loans. As discussed earlier, loans up to 20% to meet redemptions are permissible. The other logic to avail of loans is that the market is improving gradually, helped by interventions by RBI. Hence, rather than selling securities at a loss, it is better to wait out and take a loan. However, availing of loans led to negative CA or cash equivalent in a few debt fund portfolios, as we can observe from end-March portfolio disclosures available on their websites.

What is the issue then? One, the extent of negative current assets in the portfolio. Is it -2% of the portfolio corpus size (manageable)? Is it -7% of portfolio (you would think are they facing too much of redemption)? Or is it -17% (alarm bells ringing)? Two, portfolio quality. If the situation has to be reversed, the fund portfolio has to have good quality instruments, which can be sold without any impact cost on the price. If the portfolio comprises predominantly less than AAA exposures, that may be an issue.

Liquidity in bonds rated less than AAA is not adequate. Due to concerns on the economy emanating from the slowdown and potential defaults, appetite for credit-based exposures is even lower. However, the special liquidity facility for mutual funds announced on 27 April is helpful, as it allows banks to not only give loans to MFs, but also to purchase securities, for which the cost to banks is only 4.4%.

Hence, while looking at fresh deployment in debt funds, look at the extent of good quality securities in the portfolio as well as the CA component, whether it is positive or negative.

For gauging the health of a debt fund, apart from the yardstick of credit rating, look at the movement of the portfolio corpus size month-on-month. If the corpus size is shrinking consistently and significantly, it implies that the fund is going through pressure. If the corpus size is more or less stable, negative CA in the portfolio, on the lower side (say -2% or -3%) is not an issue. It also means, a fund with reasonable surplus CA is better placed to face redemption pressure, if any. Liquid funds face redemption pressure every March due to advance tax payments of corporates, hence they are not to be judged on the basis of March outflows. In other debt fund categories, the period of observation on the portfolio size movements should be over alonger period, say, the past six months. For funds with good portfolio quality, corpus movement is not significant and you may stay invested.


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