Debt investors feel the pinch after Franklin fiasco highlights risks

Investors who thought of debt mutual funds as safe products that give FD-plus returns need to revise their opinion
The closure of six debt funds by Franklin Templeton Asset Management (India) has shown that fund managers may be taking more risks with investors’ money than the latter had bargained for. Portfolios of shorter-duration funds have been found to hold lower-rated papers. And investors have discovered that the promise of liquidity in an open-end fund could be broken when the going gets tough. 

Hereafter, investors may turn more appreciative of the humble bank fixed deposit (FD). When a bank makes a loan and it goes bad, the FD investor is not immediately affected (he suffers only if his bank is closed or placed under moratorium). In a debt fund, if a fund manager’s decision goes bad, the brunt is borne immediately by the investor in the form of a hit to the net asset value (NAV). 

Investors who thought of debt mutual funds as safe products that give FD-plus returns need to revise their opinion. 
Low-risk fund: The only category that perhaps qualifies is overnight funds. These funds invest in papers of one-day maturity and hence do not display volatility.    

Moderate risk include: 

Liquid funds: They invest in papers of up to 91-day maturity. Even these funds have shown volatility in the recent past (due to, say, sale of papers by another fund). Investors should hold on to these funds through such periods. 

Shorter-duration funds: Furth­er up on the duration curve lie ultra-short, low-, and short-duration funds. Until recently, these funds were deemed low-risk. After recent events, investors or their advisors need to check whether these funds have considerable exposure to lower credit quality papers (below AA+). Investors also needs to watch out for longer-duration papers hidden within their portfolios. “These funds could have floating-rate bonds with tenure of, say, five years. But since the interest rates on these bonds reset every six months, fund managers accommodate them in portfolios of shorter-duration funds,” says Nikhil Banerjee, co-founder, Mintwalk.  

Money market funds: They invest in money market instruments like certificates of deposit (CDs), commercial papers (CPs) and treasury bills having maturity up to one year. “Not all CPs are safe even if they are rated A1+. Such papers can get downgraded rapidly. Get your advisor to evaluate the quality of CPs in the portfolio,” says Vidya Bala, co-founder, 


Corporate bond funds: Another relatively safe category that investors may consider because minimum 80 per cent of the portfolio must be invested in the highest-rated papers. But do scrutinise the non-AAA portion. Higher the percentage of AAA PSU (public-sector unit) bonds, safer the fund (since the government won’t default). Investors also need to watch out for the presence of pass-through certificates (PTCs). An NBFC could combine the cash flows from many borrowers to create a PTC. If its customers default on EMIs, the fund will be affected.   
Banking and PSU funds: This is another category deemed to be relatively safe. These funds invest in bonds issued by PSUs and in bonds and CDs issued by banks. Many fund houses today have funds in this category that invest 100 per cent in AAA PSUs and public finance institutions. “Most of these funds are offering a yield to maturity of 6-6.5 per cent. We expect another 50 basis points of rate cut, so besides this much accrual, these funds could also give some capital appreciation,” says Murthy Nagarajan, head-fixed income, Tata Mutual Fund.

Check for perpetual bonds held in their portfolios. Only if they belong to top-notch banks should you invest. “While you don’t have to worry too much about credit risk, these funds could have some duration-related volatility since their average maturity can range from one to four years,” says Bala. 

To overcome duration risk in any of these categories, the investor’s investment horizon should exceed the average maturity of the fund. This will give the fund time to recover from a hit to the NAV due to rising interest rate. If a fund has below AA+ papers, they should not be too concentrated (exposure to a single issuer should not exceed 3 per cent of the portfolio). Savvy investors should stick to portfolios with one-three-year average maturity. 

Higher-risk investments: Two categories most retail investors should stay away from currently are longer-duration bond funds and credit risk funds. The former funds hold gilts which could turn volatile. “The government could, on the one hand, face a revenue shortfall. On the other, it may have to provide a fiscal stimulus. It may have to go in for additional market borrowings in the future. If the amount is high, that could lead to a spike in long bond yields,” says Devang Shah, deputy head of fixed income, Axis Asset Management Company. 

Credit risk funds (or any fund carrying considerable credit risk) can be avoided. “We don't know wh­en the pandemic will end. If the lockdown keeps getting exte­n­ded, and the pandemic continues to impact lives, it could lead to more downgrades and defaults in lower-rated corporates,” says Shah.

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