As we all know, a mutual fund pools investor funds and invests them across assets. In the case of debt fund, these investments are made in the debt market, with a mix of debt or fixed income securities such as treasury bills or government securities.
But just like any other investment, debt mutual funds come with their own set of worries and it's very important to have a fair understanding of the risks involved.
There are two major types of risks associated with a debt MF:
A. Identifying Risk in Debt Mutual Funds (MFs) 1 . Interest rate risk: Risk of loss owing to changes in interest rates. This risk is best captured by the duration of the fund.
Credit risk: Risk of loss owing to change in credit profile of an issuer that leads either to a downgrade or default. B. Identifying Own Risk Profile
Most investors in debt mutual funds have been or still are fixed deposit customers. Therefore, it is very important to appropriately identify one’s own risk profile while deciding where to invest. Obviously mutual funds cannot guarantee returns. Therefore if one wants a risk profile that is the closest to a fixed deposit, one has to choose a debt fund that controls both interest rate and credit risk.
Right away, one can notice an inconsistency in asset allocations done over the past few years. Thus interest rate risk has always been identified as risk; since it is obviously visible as daily volatility in net asset value (NAV). However, credit risk has largely been called ‘accrual’ and the risk associated here has been underappreciated. Indeed, one has often heard a debate of ‘duration versus accrual’, where ‘duration’ denotes funds that carry interest rate risk and ‘accrual’ denotes funds that carry credit risk. Thus as interest rates turn more volatile one hears the argument that investors should move from duration funds to accrual funds. This is may not be consistent advice; for a couple of reasons:
1. A move away from interest rate risk should not automatically mean the embracing of credit risk. Thus the more appropriate advice may have been: if you don’t like volatility associated with duration funds then move to funds with lower duration (short term funds for instance) while keeping credit quality constant.
To illustrate further, suppose one were in a dynamic bond fund which was running a combination of AAA and government bonds, but of higher maturity. Then, if the investor wishes to curb the interest rate risk associated with the product, she should move to a short term fund which has lower maturity but has a similar credit risk, i.e. AAA and government bonds. However, by moving to credit risk funds that invest predominantly in AA and below the investor is adding credit risk just as she is reducing interest rate risk. This is akin to switching one risk for another and not really reducing the net risk in the portfolio.
2. A better approach is to follow an asset allocation table rather than follow tactical advice, which by itself generally follows the rear-view mirror. Thus if an investor into a mutual fund is conservative (which presumably most debt investors are) then majority of her allocations should be to products most likely to have conservative risk profiles. As explained above, these are funds that control both duration and credit risks. Full AAA funds in the low duration / short term / medium term / corporate bond / Banking PSU categories should fulfill this criterion to a large extent. Such funds should form the majority of allocation for conservative investors. For the rest, one can pursue so called ‘alpha’ oriented strategies. These could be either through funds that take interest rate risk (for instance dynamic bond funds) or those that take credit risk (credit risk funds) or both.
So long as such allocations are kept to the margin (as decided basis investor’s risk appetite), then one needn’t do tactical reallocations from time to time. It is to be noted that such tactical reallocations are also tax inefficient or may be subject to exit loads. A probable asset allocation mistake made over the past few years is slotting credit risk funds under the low risk basket where a majority of a fixed income investor’s allocations are made.
C. The First Principles Requirements from a Mutual Fund (MF)
A MF is a pass through vehicle. It pools investor funds and invests them. In the case of debt fund, these investments are made in the debt market. At some point one or more investors can ask for their money back, if it is an open ended fund. On receiving this request, the fund manager has to sell securities and meet the redemption. As far as possible after this sale has been made and the redemption funded, the character of the fund (in terms of risk profile, company concentration etc) should be similar to what it was before. This is so that the fund remains consistent for the investors who are left behind.
The important point here from an investor’s standpoint is that the majority of investments should be liquid; which means that the fund manager should be able to sell them at least in ordinary market conditions. This is important for two reasons:
1. The fund should have ability to fund its redemption and in a manner that doesn’t alter the profile of the residual portfolio. Thus if the fund has a significant exposure to illiquid securities, the fund manager will only be able to sell the liquid part. What is left will have a higher concentration in illiquid securities, which is detrimental to investors who are left behind.
2. Illiquid securities by definition don’t have a market traded price. This means that they get valued on opinion rather than on actual market discovered price. This causes a risk that the NAV of the fund may not appropriately reflect the actual value of its underlying securities. This should be a cause for concern for both existing as well as new investors into the fund. This risk is quite real as market data shows that a majority of securities rated A and below haven’t traded at all since the beginning of this financial year. This creates a large illiquidity as well as price discovery risk for funds that are holding such paper.
D. Some False Premises
There are some false premises in debt fund investing that one should be aware of:
MFs can manage liquidity via exit loads: In many cases chiefly for credit risk funds, because a significant part of the portfolio consists of illiquid securities, the fund manager relies on suitable exit loads to deter redemption. In some sense, some sort of an asset liability management (ALM) framework is used. So asset maturity is in ‘buckets’ basis the exit load periods of investors. Exit loads are no doubt a large detriment for redeeming from a mutual fund. However, by no stretch of the imagination can they be relied upon as a sufficiently high detriment.
As discussed before, MFs are pass through vehicles. They aren’t static balance sheets like a bank or non bank finance company (NBFCs) where liabilities may have a defined maturity profile. As has already been shown in the Indian market as well, if the investor concern is strong enough, she can pay exit load and redeem. This leaves the portfolio with all the problems described above in connection with illiquid securities. In some sense also, the point circles back to appropriate asset allocation. If the investor has allocated to credit risk funds under her predominant low risk bucket, then the likelihood of a panic exit is that much higher when things turn for the worse.
Even AAA can default, so why bother? : Recent events have evoked this response in certain quarters. As an admittedly extreme analogy this is somewhat akin to saying food can sometimes make you choke, so why eat! The probability of AAA defaulting is negligible. This has been proved with data over multiple decades. This doesn’t mean it can never happen. However, to use a once-in-a-blue moon default and paint a general principle is not advisable at all. Also with some due diligence, the weaker AAA can be generally weeded out by the fund manager in most cases. Conclusions
The attempt here has been to highlight some first principles that will hopefully serve well when making allocations to fixed income mutual funds. Some of the key takeaways are summarized below:
1. Investors should first be aware of individual risk profile. Assuming debt investments are first made for conservatism, a majority of allocations should be to full AAA funds in the low duration / short term / medium term / corporate bond / Banking PSU categories.
2. Credit is a risk just like interest rates are. It can lead to both positive as well as negative outcomes. The key is to allocate to both credit and duration in the so-called ‘alpha’ bucket’ and not in the core debt allocation bucket.
3. An open ended debt mutual fund should first and foremost fulfill the criterion that a majority of its portfolio should have liquidity and price discovery via the open market. This enables seamless redemption management, consistency in portfolio profile even with inflows and redemptions, and the discovery of NAV that is largely accurate.
4. A lot of discussion on credit revolves around quality of manager and depth of research process. What is equally important, however, is to ask this: Is the nature of risk being taken consistent with the vehicle being used to take the risk? More specifically, are open ended mutual funds the appropriate vehicle to take on such positions?
Suyash Choudhary is the head of fixed income at IDFC Asset Management Company.
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