personal finance

Your debt mutual fund portfolio in the age of coronavirus

By Balacharan R

The nation and large parts of the world are under lockdown, with the full extent of economic consequences unknown. So, what steps should investors take to protect their debt fund portfolio from being ‘infected’ by the virus? We examine this question from the perspective of three risks which investment in debt is exposed to: credit, liquidity and duration risks.

Credit risk

Small businesses, which may not have as much staying power and liquidity as large corporates, may face the brunt of the pandemic. Banking and PSU debt funds and many Corporate Bond funds may escape unscathed with their portfolios dominated by corporates/banks/PSU’s. But credit risk funds, some of which appeared to have reasonable risk-reward ratio until two weeks back (before the lockdown announced by the Prime Minister), face tremendous uncertainty as some of their investee companies at the lower end of the credit spectrum, face turmoil and looming default. Fresh investments in credit risk funds can be paused, and cautious investors may consider pruning existing exposure.

Many funds, apart from credit risk funds, have invested in AT1 bonds, which created panic in the last few weeks, on account of a move to write them off by Yes Bank. Investors should constantly scan debt fund portfolios for exposure to AT1 bonds of fragile private sector banks, with risk averse investors avoiding funds invested in them. Weak PSU banks have met AT1 bond obligations till now with some apparent help from the government, but it is uncertain if this support will continue. A clear conclusion from the Yes Bank AT1 bond debacle is that the risks of these bonds cannot be gauged by rating agencies and institutional investors, and certainly not the retail investor.

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Select Banking and PSU debt funds and certain Corporate Bond Funds are better positioned for medium-term surplus deployment, in today’s uncertain scenario. Sticking to mutual funds from pedigreed backers like large banks may be a safer option.

Investors may note that the supreme safety offered by deposits in SBI, does not extend to the mutual fund promoted by it, as investors bear 100% of the credit risk, though SBI MF has acquitted itself reasonably well, when others floundered. Investors can skip fund houses, which have let them down badly on the credit risk front, time and again.

Fallen angels don’t rise again

Investors with asset allocation across equity and debt, would have faced a substantial erosion in their equity portfolio of about 40% from peak to low this year. A significant difference is that equity indices tend to recover over the long term. The BSE Sensex fell more than 50% from its peak, during the 2008-9 financial crisis. It subsequently not only recovered its losses, but went on to double from its pre-financial crisis highs. This scenario unfortunately does not work for credit losses in debt, which tend to become permanent.

The credit markets characterize debt instruments which fall below investment grade – BBB minus – as fallen angels. Fallen angels rarely rise back, in the debt world. Prospects of recovery are remote in the likes of the erstwhile “AAA” rated ILFS, Yes Bank AT1 bonds and others.

RBI has eased the pain of borrowers through moratorium/deferments and SEBI has provided some leeway to credit rating agencies on defaults ascribed to the lockdown. But financial markets may not be as forgiving to fallen angels unable to meet their obligations, with the prospect of NAV erosion in the debt funds holding their securities.

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Duration risk

10-year benchmark bond yields collapsed when demonetization was announced, resulting in a windfall for long duration investments, as the banking system liquidity went up, when depositors rushed to dump demonetized currency in their banks. We have not seen such a dramatic fall in yields till now, perhaps because of FPI selling, the expected deluge of government bonds to fund the stimulus package, and absence of open market operations by RBI yet.

Though today’s scenario does not portend duration risk, sticking to 2-3 year duration debt funds may be a wise strategy.

Liquidity risk

Despite RBI taking significant liquidity easing measures to counter the effects of the pandemic, liquidity for mutual funds has been tight on account of factors like investor redemption. During the 2008-9 financial crisis, debt funds saw an unprecedented net outflow of more than Rs 50,000 crores, forcing RBI to step in to infuse liquidity into mutual funds through banks.

The debt mutual fund industry has since grown into a Rs 14 lakh crore behemoth, with systemic importance to the economy. SBI rescued Yes Bank, despite its terrible track record in lending, and abysmal governance standards. It is therefore likely that a relatively cleaner industry like debt mutual funds, will get the necessary liquidity support from RBI when in need. Meanwhile, the cautious investor can stick to mutual funds backed by big banks with good track record, while being cognizant of the market risks that every mutual fund scheme carries.

With liquidity needs potentially backstopped by the central bank and duration risk in the backburner for the moment, debt fund managers singed by IL&FS/DHFL/Vodafone/Yes Bank etc would need to once again focus on credit risk which may hit them from unexpected quarters, in the current uncertain age of the coronavirus. For example, if pristine obligors in AAA rated securitisation deals, renege on their contracts,
citing force majeure, then it’s truly apocalyptic times. Investors in debt would now be joining equity investors, in periods of stomach-churning volatility.

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(The writer is a fixed income investor and erstwhile corporate banker)


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