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.

Should Fund Houses Fear Big-Ticket Investors?

Media reports suggest that a questionnaire from the country’s largest bank -- State Bank of India (SBI) has sent several fund houses running for cover. Apparently SBI invests substantial monies in debt mutual funds; last week, the bank sent a questionnaire to fund houses, seeking information about their investment practices and policies. Among others, SBI has asked for information on fund houses’ policy for compensating investors in the event of a loss incurred due to a default or downgrade. Clearly, the JPMorgan Mutual Fund episode continues to rankle investors.

Investors wanting to know more about a fund house’s investment practices is understandable. Indeed, one expects them to perform such due diligence before making an investment, rather than after investing. The curious part pertains to seeking compensation in the event of a loss. It doesn’t take a genius to figure out that mutual funds are market-linked instruments; hence the possibility of incurring a loss cannot be ruled out. Given that fund houses operate as pass-through structures, expecting them to compensate investors for a loss incurred in the normal course of investing seems farfetched. So why would a behemoth like SBI seek such information? For the answer, let’s step back in time.

Hail big-ticket investors!

The mutual fund industry’s fondness for big-ticket investors (institutions and high net-worth individuals) is no secret. Over the years, this liking has manifested itself in various forms: institutional plans with liberal expense and load structures (versus retail plans), launch of fixed maturity plans that enabled a handful of big-ticket investors to make quasi-PMS investments. In the 2008 meltdown, several fund houses did their best to protect large investors in debt funds, by transferring illiquid securities to equity funds. In effect, liquidity was provided to large investors at the cost of retail investors (who largely invest in equity funds). Over time, it took intervention from the market regulator SEBI (in the form of abolishing differential expense and load structures, and instituting the 20-25 rule, among others) to create a level playing field. 

But then old habits die hard. Perhaps some big-ticket investors have a sense of entitlement which leads them to believe that mutual funds should be structured as  risk-free (at least in part) investments for them.           

The counterview 

Data from AMFI reveals that as of Sep 2015, debt and liquid funds accounted for roughly 67% of mutual fund assets. In both the segments, a lion’s share (62% in debt funds and 92% in liquid funds) was held by institutional investors. Simply put, a bulk of mutual fund assets come from institutional investors. Fund houses can claim that they are obligated to offer these big-ticket investors preferential treatment. But such thinking is flawed.

Any serious fund house knows that long-term assets are the key to survival and growth. Yet again, data reveals that fund categories wherein retail investors dominate tend to display longer investment horizons versus categories wherein institutional investors dominate. Hence, it is in the interest of fund houses to offer retail investors a fair deal.

If fund houses find themselves in a vulnerable position, they must shoulder at least part of the blame for having failed to democratize investments. Several fund houses have been guilty of chasing short-term institutional monies and failing to develop a strong retail investor base.

It will be naïve to believe that any fund house will offer to compensate SBI for losses incurred in its schemes. It’s high time self-respecting fund houses send an unambiguous message: The era of offering preferential treatment to big-ticket investors (and treating retail investors as second-class citizens) is over. It is in the best interest of fund houses to come to terms with this realisation and act on it at the earliest.

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.