Should Investors Fear Debt Funds Taking Credit Risk?

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.

Why Investors Shouldn’t Deify the Portfolio Manager

In the recent past, debt mutual funds have witnessed two significant events. Oddly, these seemingly unrelated events have evoked an identical response from investors.

In the first week of February 2017, RBI’s Monetary Policy Committee unanimously voted in favour of keeping policy rates unchanged. It was widely anticipated that the central bank would cut rates in keeping with the accommodative stance it has adopted over the last two-odd years.

Debt markets reacted negatively to the pause in rate cuts, with bond yields surging sharply.

Several portfolio managers running debt mutual funds had increased the maturity of their portfolios, to capitalise on the anticipated rate cut. Expectedly, their performance took a significant hit.

Last week, some debt funds from Taurus Mutual Fund were in the news on account of their poor showing; the funds posted losses ranging from 7% to 12% in a single day. The reason—they were invested in debt instruments from Ballarpur Industries. A credit rating agency downgraded the issuer’s long-term rating, on account of “delays in debt servicing by the company”, among others. The episode brought back memories of similar instances that have occurred in recent times.

In both the aforementioned instances—RBI keeping rates unchanged, and Taurus Mutual Fund’s credit bets—it is evident that portfolio managers were pursuing distinct investment strategies. In the former, managers were engaging in duration plays, while in the latter, taking credit risk was central to the strategy. However, both strategies came a cropper to the chagrin of investors.

Deifying the Portfolio Manager

Since then, I have had conversations with several investors. The most common refrain was that portfolio managers are to blame. But the grouse wasn’t along the lines of the justifiable “portfolio managers need to take responsibility for poor investment decisions”.

Rather it was akin to “how could the portfolio manager make a mistake?”

On digging deeper, I learnt that their rationale was: The portfolio manager is an investment expert. He gets paid a sizeable compensation for running the fund. Hence he shouldn’t be making a mistake, and as a result, exposing investors to a loss.

I was surprised to note that many investors view the portfolio manager like a superhero who cannot err. And therein lies a fundamentally flawed line of thought.

Selecting the Portfolio Manager

Admittedly, the portfolio manager plays a significant part in determining the fund’s fortune. Also, it must be stated that portfolio managers encompassing the entire spectrum—mediocre to supremely talented—exist in the mutual fund industry. Hence, the importance of selecting the right portfolio manager cannot be overstated.

One would expect the manager to be skilled, and have proven his mettle over the long haul. He must have successfully plied his craft across a market cycle. Furthermore, he needs to demonstrate confidence in his abilities by investing substantial monies in his funds alongside investors.

Simply put, the portfolio manager must indisputably earn his stripes before investors can entrust him with their monies.

Pragmatic Expectations and Evaluation

On their part, investors must be pragmatic while evaluating the portfolio manager. Investors would be justified in expecting the manager to get more calls right than wrong. For instance, a manager running an active strategy is expected to beat the benchmark index over the long haul.

However, expecting him to never err, or deliver a positive return consistently is unrealistic. Even the best of managers, can and will make a poor investment decision at some point. That is par for the course in market-linked investing.

Idolising the manager can also hurt investors by preventing them from making an accurate evaluation when the manager hits a purple patch. Consider the case of a manager who takes on unduly high risk to clock superior returns.

The Flipside of Deification

There’s a marked difference between holding the manager to high standards, and having unrealistic expectations. The latter can lead to disenchantment, and investors turning their back on mutual funds.

Sadly, investors whom I interacted with seemed to be leaning in that direction. They have jumped to the conclusion that since the portfolio manager cannot guarantee success, they are better off investing on their own. For most, that isn't the right course of action.

What Investors Must Do

Investors would do well to understand how portfolio managers operate, and then devise an evaluation system that works for them. A manager who fails to retain the investor's confidence should be penalized.

But deifying the portfolio manager and expecting him to deliver in a like manner is neither rational, nor in the investor's interest.

Beware of investment advice which reads...

Markets are in a celebratory mood. Election results not only met but surpassed expectations with the BJP-led NDA gaining a thumping majority. With markets surging northwards, it comes as no surprise that the performance of mutual funds has started looking up too. Pick up any business daily, and you are likely to find articles extolling virtues of mutual funds, discussing their performance and favoured investment areas. And then, there are experts dishing out advice on what investors must do. While some of the advice is sage, there is also a lot of rather disconcerting advice doing the rounds. I have chosen three pieces of investment advice which are at best half-truths, and at worst completely incorrect.

1. Dynamic bond funds work like a silver bullet

Will the RBI governor cut rates in the forthcoming monetary policy review or won't he? That seems to be the million dollar question at the moment. And this in turn, has led to a lot of discussion regarding dynamic bond funds. Simply put, the latter have a fluid investment style wherein the manager takes active duration bets, based on his assessment of where interest rates are headed. The manager's flexibility to position the portfolio across the yield curve is seen as a silver bullet. Sadly, there is a difference between plying a flexible approach and being successful at it. There are enough instances of even skilled bond fund managers woefully misreading the direction of interest rates. 

A case in point was mid-2013 when RBI's steps to bolster the weakening rupee spooked debt markets; at a time when consensus suggested that rates would soften, they rose sharply. As a result, several managers who had positioned their bond fund portfolios for a softer interest rate regime were caught on the wrong foot. Don't get me wrong--I'm not suggesting that dynamic bond funds are without merit. All I'm saying is: don't think of them as a magic potion for all woes. Even conventional short-term bond funds (which admittedly operate in a narrower band of say one-three years) are capable of adding value to the portfolio. Don't dismiss seemingly plain-vanilla products (read short-term bond funds) in favour of dynamic bond based on a misconception.

2. If the manager follows a consistent approach, the fund will perform

To be fair, a consistently plied approach is a positive as it infuses predictability. But to suggest that the same in isolation is a surefire recipe for success is naive. It takes a lot more for the fund to succeed. To begin with, it helps to have a skilled portfolio manager who is playing to his strengths. As for the process, it needs to be a robust one which is executed with skill. 

To better understand this, consider a process that relies heavily on making the most of mispricing opportunities between the cash and derivatives markets, or one that results in a substantial structural bias for certain stocks/sectors, or one that relies solely on momentum to deliver. These are examples of processes that aren't inherently robust, and ones that will succeed only in specific market conditions. Their consistent application won't automatically make the fund better equipped to deliver. Execution is no less important: consider a process which is rooted in valuation-consciousness and a long-term orientation. The robustness of the process notwithstanding, should the manager keep getting snared in value traps due to poor execution, the consistent approach is likely to be of little help.

3. Evaluate funds based on their holding pattern in top 10 gaining stocks

This one's rather bizarre. If it wasn't bad enough that investors were being misled to evaluate the performance of equity funds over shorter time periods like 1-year and 3-years (with scant regard for the risk-adjusted return showing), now apparently whether or not the manager was invested in the top 10 gaining stocks is a parameter to consider. To my mind, this demonstrates a poor understanding of both--the working of a mutual fund and what one must expect from it.

Funds are run based on their investment mandate and the manager's investment philosophy. A number of parameters such as market capitalisation, nature and quality of business, and valuations, among several others come into play. An investment universe is drawn out and stocks chosen from therein. Though it would certainly help if the best performing stocks were to feature in the manager's picks, it is certainly not obligatory. Let's not forget that in a sharp market upturn, it is often speculative, high-beta fare that fares the best. And the latter need not be the kind of stocks that every manager wishes to invest in. 

Broadly speaking, the test of a manager and his strategy should be the ability to score over the fund's benchmark index and comparable peers over longer time frames (read at least five years) across the return and risk-adjusted return parameters. Whether or not the manager is invested in the top 10 stocks is of no consequence.

In conclusion, there’s a lot of investment advice available in public domain. Investors on their part would do well to be discerning and act on advice that is apt for them.