Don't Treat Debt Funds Taking Credit Risk Like Pariahs

The JPMorgan Mutual Fund episode continues to reverberate in the investment community. The focus has seemingly shifted from the two affected funds to the investment strategy of taking credit risk (also referred to as high-yield investing). Media reports suggest that market regulator SEBI has sought details on investments in lower-rated securities from fund houses; also, it has been reported that SEBI has asked fund houses to not rely solely on credit ratings while investing in debt securities. Consensus suggests that fund houses have erred by taking credit risk, and as a result, investors’ interests have been compromised with. But this line of thinking is both myopic and fundamentally flawed.

To begin with, let’s understand what the strategy of taking credit risk (or high-yield investing) entails. The portfolio manager invests in securities with a lower credit rating. Such instruments offer a higher coupon rate (versus securities with a higher credit rating); furthermore, there is a possibility of the bond price appreciating if the credit rating is upgraded. Does this investment strategy entail risk – yes, it does. There is risk of the issuer defaulting on the payment of interest and/or the principal amount. Often such bonds can be illiquid which further accentuates their risk profile.

Given the risks, did fund houses and portfolio managers err by adopting a credit-based strategy? No, and here’s why: The strategy of taking credit risk is as legitimate as any other. Several managers have plied it successfully and delivered pleasing long-term results for investors. That the strategy entails risk doesn’t make it faulty. Some experts have claimed that investors are better off investing in debt funds that follow the duration strategy. That’s a weak argument because failing to accurately read the direction in which interest rates will move can also lead to losses.

The only reason funds with credit risk are in focus at the moment is the JPMorgan Mutual Fund episode. Oddly, over the years when these funds delivered attractive returns (and inherent risks didn’t surface) no concerns were raised. Therein lies the crux of the matter. Mutual fund investing is not without risk. Sure, some strategies are riskier than others, but risk is omnipresent. 

Treating debt funds with a credit strategy like pariahs is a knee-jerk reaction. A prudent approach will be for investors to acquire an unambiguous understanding of the risk involved, and then decide if they are comfortable taking on the same.

For instance, before investing in a debt fund wherein the credit risk strategy is employed, investors must ask themselves the following questions:

• Does their risk appetite allow them to invest in the fund?

To gauge one's risk-taking ability, it might help to visualize a scenario wherein testing conditions (read more downgrades and underperformance) prevail for a prolonged period. If investors believe that they are likely to push the panic button, then these funds aren’t for them. 

• What is the apt allocation for the fund in the portfolio? 

An investment advisor/financial planner can help decide if the fund should be utilised as a core holding or a supporting player in the portfolio. Clarity on this front will also help pragmatically evaluate performance, and decide on the fund's continuation in the portfolio.

• Is the portfolio manager adept at taking credit bets?

Not every manager has the skills to successfully ply the strategy. It is pertinent that the manager’s skills are in sync with the strategy. Seek managers who have conviction in the strategy over those who deploy it because it is the flavour of the season.

• Is the fund house trustworthy? 

Notwithstanding the kind of fund investors are seeking, the importance of being invested with the right fund house cannot be overstated. This aspect is only accentuated in times of adversity. Investors should select fund houses which have a track record of being investor friendly.

Investment Lessons From The JPMorgan Mutual Fund Episode

In the recent past, JPMorgan Mutual Fund has been in the news for all the wrong reasons. To begin with, it was reported that two of its debt funds i.e. JPMorgan India Treasury Fund and JPMorgan India Short Term Income Fund have suffered substantial losses on account of investments in an auto ancillary company—Amtek Auto. The latter is facing a financial crisis of sorts; in its communication with stock exchanges, it has mentioned a decline in operational performance, cash flow mismatch and steps being taken to counter the same. To further worsen matters, in Aug 2015, CARE (a rating agency) suspended its ratings of Amtek Auto stating that “the company has not furnished the information required by CARE for monitoring of the ratings”.

Expectedly such developments can hurt the price of the company’s debt issuance, and in turn the performance of mutual funds invested in these papers. Furthermore, the fund house decided to limit redemptions in the aforementioned funds “in the general interest of the unit holders”.

This entire episode has been curious to say the least. However, it offers some important investment lessons.

1. Evaluate the fund house’s character

Mutual fund investors are often guilty of not evaluating the fund house’s character before investing. This can prove to be a costly miss. The fund house’s character will go a long way in determining its policies, attitude towards investors and even the long-term performance of funds. While it would be unfair to draw conclusions on JPMorgan AMC based on a single incident, the asset manager’s decision to restrict redemptions does not portray it in a good light.

It must be clarified that the Scheme Information Documents of both funds explicitly state that the asset manager can restrict redemptions. Hence JPMorgan AMC’s actions are in line with stated policy. The trouble is that both funds are open-ended in nature wherein the implicit assumption is that investors are free to liquidate their investments at market price when they choose to do so. In the Indian mutual fund industry, this is the norm. On this count, the AMC has let its investors down. 

If investors in the fund are willing incur a loss, while liquidating their investments, that choice should be available to them. More importantly, if the AMC is truly concerned about investors’ best interests, it can compensate them for the losses incurred with their own monies. Conversely, limiting redemptions while they put their house in order amounts to penalizing investors for the AMC’s mistakes. A crisis will typically reveal true character, and in this case, JPMorgan AMC doesn’t come out smelling of roses. Hence it is pertinent that investors pay attention to the fund house’s character before investing. 

2. Debt funds are not risk-free investment avenues

A popular misconception suggests that debt funds are risk-free investment avenues. Admittedly, certain debt fund segments do expose investors to less risk versus say an equity fund. But treating them as risk-free investment avenues is plain erroneous. Being market-linked investments, debt funds are prone to risks such as interest rate risk and credit risk. Investors who wish to invest in risk-free instruments should stick to avenues such as small savings schemes (which are backed by a sovereign guarantee). 

Let’s focus on credit risk which is relevant to the case. Debt fund managers are known to take credit bets (invest in lower rated securities) to deliver outperformance. While the investment strategy is commonly deployed, as is often the case, some portfolio managers are more skilled than others, resulting in varying results. Clearly in the case of the two JPMorgan funds, the results were less than desirable.

It isn’t uncommon for some distributors and advisors to present debt funds as risk-free investment avenues. Irrespective of the reason – ignorance or mala fide intent – investors can and do end up being misled. Hence, they would do well to understand the true nature of debt funds before investing.

3. Participate in the investment process 

Yet again, this episode reinforces the need for investors to actively participate in the investment process. Admittedly, that is easier said than done. But investors should find motivation from the fact that their personal wealth is at stake. I’m not suggesting that investors become investment experts. Then again, being completely uninvolved is not prudent either.

For instance, while it helps to engage the services of an investment advisor, blindly acting on his advice isn’t recommended. Quiz him on his recommendations—enquire about the rationale, the risks involved, alternatives and how they stack up versus his recommendations. Additionally, it would help to read up about investing from independent and credible sources. The intention is to become informed investors. Apart from making better investment decisions, this will also help investors deal with testing periods in an assured manner.