In October 2008, fixed maturity plans (FMPs)
were in the news for all the wrong reasons. The financial crisis had set in,
and equity markets had crashed.
Debt markets weren’t spared either: it was
feared that papers issued by some real estate and broking firms, among others
would default. Several debt funds, including FMPs were heavily invested in such
instruments. Amidst tight liquidity, there was a run on fund companies, which
in turn led to distress sales, and net asset values (NAVs) crashing. The latter
fuelled more panic, and further distress sales.
Roughly nine years hence, I see a similar
narrative playing out in the context of debt funds taking credit risk.
Admittedly, the level of fear isn’t even remotely comparable as yet, but make
no mistake, the narrative is similar.
Every time a credit rating agency
downgrades the rating on an instrument, it makes headlines.
Media lists which mutual fund portfolios hold the downgraded paper, alongside
the allocation. Words such as default and loss are liberally tossed
around, leading to fund investors hitting the panic button.
So should investors fear debt funds that take
credit risk? Let’s find out.
The strategy of taking credit risk (or
high-yield investing) entails investing 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 price
appreciating if the credit rating is upgraded.
Does this investment strategy involve
risk—indeed, it does. There is risk of the issuer defaulting on the
payment of interest and/or the principal. Often such bonds can be illiquid
which further accentuates their risk profile.
Given the risk, should investors shun funds
using a credit risk-based strategy? No, and here’s why:
The strategy of taking credit risk is as legitimate as any other.
Several portfolio managers (both in India and globally) have plied it
successfully and delivered pleasing long-term results. A strategy
doesn’t become faulty simply because it entails risk.
Some experts argue that investors should only
invest in debt funds deploying the duration strategy. That’s a weak
argument because failing to read the direction in which interest rates
will move, can also lead to losses. A case in point is the performance of debt
funds in February 2017, when contrary to expectations, RBI kept policy rates
unchanged.
Also, this is a case example of missing the
woods for the trees—mutual fund investing is not without risk.
Sure, some strategies are riskier than others, but risk is
omnipresent.
Investors will do themselves a huge
disservice by treating debt funds with a credit strategy like pariahs,
and hitting the panic button in reaction to every news story.
Instead, a prudent approach will be to acquire an unambiguous understanding of
the risk involved, and then decide if they are comfortable taking on the same.
It's worth noting that when investment decisions
are based on a combination of fear and ignorance, the results can be rather
unpleasant.
