Individuals investing in corporate bonds are a worried lot because of a spate of downgrades and defaults. The downgrades on corporate paper are forcing some mutual funds to mark them to market and cut the net asset values of debt funds.
Analysts say if an individual is planning to invest in debt mutual funds, then he should do in those funds where the fund manager is not just chasing returns by taking higher credit risk. An investor must consider his risk appetite and time horizon before investing. As all debt funds have credit risks, interest rate risks and liquidity risks, investors must analyse them carefully before investing.
Turmoil in debt market
The debt market turmoil started with Infrastructure Leasing & Financial Services (IL&FS) default last year which led to a liquidity squeeze. A week ago, two Reliance ADAG companies Reliance Home Finance and Reliance Commercial Finance have been downgraded to default grade and ICRA has cut ratings on Yes Bank s bond because of the bank s weak financial results for the fourth quarter.
It is estimated that rating agencies have downgraded corporate debt worth $7.5 trillion from September last year to March this year. As per CARE Ratings, for the first time in six years, the number of downgrades is more than the number of upgrades.
Trouble in FMPs
Recently, Kotak Asset Management Company (AMC) deferred full redemption in six fixed maturity plans (FMPs) that held papers of two Essel Group subsidiaries. In fact, nine AMCs including SBI AMC, HDFC AMC, Reliance Nippon Life AMC, Franklin Templeton Asset Management (India), Aditya Birla Sun Life AMC and UTI AMC have lent to Essel Group across 87 schemes, including FMPs and open-ended debt funds.
Even HDFC AMC has extended the maturity of one of its FMPs maturing on April 15, 2019 to April 29, 2020 citing current interest rate scenario and portfolio positioning. The yields prevailing in the short maturity bucket present an option for investors to lock in their investments at current prevailing yields, an HDFC AMC statement to investors said.
All FMPs are close-ended funds with a fixed maturity period and the corpus is invested in debt instruments with maturity matching the tenure of the scheme. For fund houses, the investment objective of FMPs is to generate returns and protect the capital invested as the schemes invest in debt products with a fixed maturity. But as AMCs are deferring full redemption in FMPs, retail investors are a becoming wary of investing in debt funds.
Tread with caution
Till the turmoil in the debt market began in the mid of last year, investors were looking at debt mutual funds as an alternative to bank fixed deposits. Moreover, debt funds are more tax-efficient than fixed deposits which attracted a lot of investors in the highest tax bracket.
Corporate debt paper carry higher credit risks than government bonds. Credit risk takes into account whether the bond issuer is able to make timely interest payments and pay the principal amount at the time of maturity of the bond. If the issuer is unable to do so, then the particular bond is likely to default.
Investors should not invest in funds that have high exposure to companies having a large leverage. Higher the maturity profile of the fund, more prone it is to interest rate risk. So, any change in the price of a bond because of changes in the interest rate can affect investors. In case of increasing interest rate scenario, it will be positive for funds having a shorter maturity profile. On the other hand, a falling interest rate scenario will be beneficial for those funds which have a longer maturity profile. So, if you invest in debt funds, align investment horizon with that of a fund which will help to mitigate the interest rate risk.
In the current context, investors should also look at liquidity risks of the funds, which means how quickly the fund manager can sell the particular paper in case of any downgrade. Corporate bonds of high-rated companies are more liquid than the lower-rated paper. If the fund manager is selling the paper under pressure, then investors will suffer losses.