A trader at a computer monitor at a brokerage firm in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)

The Mutual Fund Show: How Should Investors Approach Debt Mutual Funds?

After the markets nosedived last week and the concerns surrounding insolvent infrastructure firm Infrastructure Leasing & Financial Services Ltd., debt mutual fund investors would be worrying about their money.

There is some sense of panic as corporates invested in liquid funds get rattled even with a day of negative returns, said Dhruv Mehta, chairman of Foundation of Independent Financial Advisors, on BloombergQuint’s weekly series The Mutual Fund Show.

Some funds with exposure to IL&FS have shown negative returns over one to three months and this adds to the uncertainty, he said. “There has never been the instance of a AAA paper defaulting though the interest rate spike in 2008 led to mark-to-market losses. However, a credit risk would be difficult for the market to digest.”

Duration and credit risk are the two factors an investor must study before selecting and investing in debt funds, said Tarun Birani, founder of thinkinman.co.in. Birain suggested investing in AAA-rated accrual funds at current levels.

While Birani suggested incremental investments for the next 3-6 months in the ultra-short-term category, Mehta pitched for investing in overnight funds for the same time duration.

Watch the full conversation here.

Edited transcript.

One black swan event has led to the NAV of some of the AAA rated funds coming off. One can argue that staying invested for the long term will help digest the fall, but you can’t ignore the hit. How high or low is the probability of something like this getting reenacted in some of the others? Is it even predictable?

Birani: There is Rs 2,500-crore worth of IL&FS paper with the mutual fund industry. Out of that, Rs 400 crore is in liquid fund space. Paper of this nature, in liquid funds, is something we need to watch out for as rating agencies or regulators. The IL&FS papers were reaffirmed as AA+ in August, and then within 45 days, they’ve become D. No one could have anticipated that. If you see the current fall in funds, they are mostly credit risk funds. These funds’ objective is that they will have those credit risks in the portfolio. We have normally seen that good credit risk funds have 50-70 securities. So, no individual holding is more than 1-2 percent. So, if you are getting into something where 2 percent, 200 basis points extra returns you want to generate, you have to bear this kind of risk. So, this needs to be communicated very clearly to the investors that credit funds come with this kind of risks. If you are not comfortable with this kind of risk, then you get into AAA rated or a government treasury oriented short-term security. That’s where investors should park their funds.

If somebody wants to put in money, instead of a savings account into a fund or already has, is there way of safeguarding it? Rather, is there is need to safeguard in the first place?

Birani: The NBFC space has Rs 75,000-crore exposure to debt securities, just 5 percent of the overall portfolio. Housing finance is around 11 percent which is around Rs 1 lakh crore plus. In terms of risks, I don’t see that as a very big issue. But today, we are seeing liquidity risk even when Rs 500 crore paper is sold, there is a very big differential in yields which we are seeing in last couple of days. We run that risk currently. Over the period of time, once the situation gets better, things will be normal as usual. I don’t see that as problem.

If you have Rs 5 lakh to be parked, would you be comfortable doing it in current instruments or would you enable some safeguards?

Mehta: The mutual fund system as whole does not have systematic risk. However, for any investment you need to take little care. Today if you want a pure liquid fund, even if you want to put money only for 1-3 days, then there is category called as an overnight fund where the mutual fund will invest only in the CBLO (collateralized borrowing and lending obligation) with the Reserve Bank of India. So, there is zero risk. And the purpose is also that it could be 1-5 days. The liquid fund is typically for a period of 30-90 days. The lesson is that there can be black swan event in one paper. If the fund has a very high exposure to it, then you get affected more. Otherwise, if it is diversified portfolio, we see that in the other liquid funds, the impact is not so much.

So, the care one has to take is you have to take is diversify your investment across funds. The second care you have to take is that any scheme that you are putting your money in, even a 10 percent allocation in debt fund is large. For debt, you need a greater diversification. When you diversify credit risk and you have exposure of 2-2.5 percent for every issuer, that again will diversify your risk. If you take these two-basic care, to divide yourself among 3-4 fund houses and within that also the schemes. We have found that in some schemes there are 0.5 percent exposure but, in another scheme, it has 5-8 percent and that scheme comes under pressure. In terms of diversification of the risk, overall, I don’t think of longer term because in India the regulator is quite alert, RBI and SEBI. There could be problem for 15-20 days. Anybody who has very short-term liquidity should look at overnight fund which is the safest.

What if the fund gets big redemption request? What happens in such a scenario?

Mehta: What happen in case of the DSP incident, is when you have a large redemption, you might sell at a distressed price. So, when the pricing gets changed, if the paper which was trading at 8 percent gets traded at 11 percent, the whole industry has to market all the papers at 11 percent.

If redemption were to come up, is there a risk to net asset values?

Mehta: There is some NAV risk in the short-term because of redemption pressure surrounding the end of the quarter. But once that gets over, you will find that liquidity will find its way back. You will see that pressure for the next 30 days.

But as things stabilize, the money will come back. If you are an investor with longer term horizon, long term for the debt market which is 3-6 months, you should not be worried.

Birani: It is just a matter of time right now. We are seeing this current situation unfolding due to a lot of such issues happening right now. Investors with longer horizon should not get impacted negatively because of it.

Is there nervousness about redemption pressures rising? Have the asset management companies experienced it?

Mehta: It is isolated and not industry-wide. The particular schemes that have exposure to IL&FS or some other paper that the industry feels the need to be more vigilant, have seen some pressure.

Corporate treasuries are watching, and they want things to stabilize soon. Therefore, one has to watch that the redemption does not accelerate. Lot of corporates are on alert. If you see the stabilization, if IL&FS is to start making its payment. If it gets infusion by way of rights issue, then everything will be normalized.

If you want to park money now for the next 3-6 months, what category or names you would choose right now?

Birani: The suitability and tenure are very important right now. If you are looking at 3-6 months horizon, one needs to look at ultra-short-term category. There we need to look at funds and the credit rating of the paper in their portfolio.

Apart from that, the accrual space looks very interesting right now. Anybody who has horizon of more than 2-3 years, the kind of yields you are getting right now is very exciting.

How does the accrual category work?

Birani: Accrual category schemes make most of its money through the accrual income, basically the interest coupon income. These securities are held till maturity and most of the fund houses have such schemes.

Is it branded under accrual funds?

Birani: They have two big categories, one is the corporate bond category which is AAA rated category and second, the credit risk category, which has lower than AAA rated funds. I feel at this point of time, the AAA rated with an 8 percent plus yield to maturity is extremely attractive scenario. You have to look at today’s current scenario. The real interest rates are positive. So, CPI is at 3-3.5 percent right now. In 2013, our inflation used to be 7 percent. There the real interest rates were negative at that point of time. We were seeing so much of physical asset investment, the gold, real estate was giving good returns at that point of time was because of it. But today, if I look at financial assets, because the inflation is so low right now, it makes lot of sense to be into financial assets and that too fixed deposits. Just look at today’s FD. The one-year FD around 6.5-7 percent of what it gives right now. Post tax and if you are in the highest tax bracket you make up only 5 percent return. A triple A rated accrual fund would give 6.5-7 percent return post tax in current scenario, which is good.

Mehta: If I have to put my money for 0-6 months, I will just put it in overnight funds. But for longer duration, there is an opportunity to invest in credit risk category. Typically credit needs to be priced. Over the last 2-3 years, even in benevolent environment, credit spreads come down. People don’t price the risk. Now that the event has happened, the credit will be priced. You are getting paid for the risk you are taking. It is an appropriate time. If you are putting money for next 2-3 years, this is good time to get it into credit. All the people are going to borrow money now and if there is credit risk they have to may appropriate and right premium. So, you as an investor are getting paid for the risk that you are taking. You could end up with double digit returns because after three years if spreads come down, the perception of credit falls. You could end up making double digit returns.

Birani: If you want to take risk, I would rather take the risk in the equity space. I would not take risk on the debt side. In that space, AAA category looks attractive right now. And I feel one need to be invested at this point of time.

Also read: The Mutual Fund Show: Don’t Break These Rules Of Investing