Investors look at debt mutual funds differently after Franklin Templeton saga

By Harshad Chetanwala

Debt mutual funds were considered a completely safe investment option almost two years ago. Risk-averse investors, who were looking to generate marginally better returns than savings bank accounts or fixed deposits, preferred to invest in debt mutual funds. This perception has changed in the last couple of years.

The change started in September 2018 when IL&FS defaulted on its bond payments. Debt fund investors suddenly started witnessing frequent and large devaluation of NAVs of some funds, along with defaults and downgrades of companies where the funds have invested. The perception undergone further change in April 2020 when Franklin Templeton shut six of its debt-oriented schemes that had cumulative assets of around Rs 25,000 crore.

Today, investors scrutinize debt funds almost the same way they do equity funds. Even the fund houses are aware of the changing trend. They know that they cannot simply stand up and say that investors need to understand the risk they take while investing in debt funds. The fund houses have started focusing on their credit standards when it comes to investing. The undue risk to generate an additional return by looking at lower-rated bonds can have a massive impact on investors in a credit crisis. They are looking at their investment from a liquidity and credit risk perspective more thoroughly.

Many individual investors were hit by these events in debt funds. Risk-averse, retired investors and those who were nearing their retirement rely a lot on debt funds as they are intended to have a substantial allocation in it. Hence, the way to assess the debt funds before investing is going through a transition which will help investors to make a more informed decision.

Looking closely at risks

Regular credit and liquidity related crises have highlighted the need to look at these risks closely. This prompted investors to stop looking at debt funds only from the return perspective. Earlier, investors were considering funds that generated higher returns for investing because debt funds were perceived to hardly have any risk.

There are many institutions in the debt market where the funds can invest and the risk-return grid work in the same way as any other investment option. Companies that offer higher interest rates than their peers and other companies have additional risks. That is always the reason why they are willing or forced to offer that additional interest. Any exceptionally high Yield-to-Maturity (YTM) can be an indicator of additional risks. This aspect is now getting the due attention of investors.

Portfolio: Quality and diversification matters
The underlying portfolio gives a lot of information about the fund and how the fund is managed. Portfolio concentration is another good indicator of risk. If the holdings in some companies and their group are on the higher side, the risk on such investment is higher. This has now been realized by most of us when we witnessed NAVs plunging during the credit crisis in companies or their group.

Average maturity gives a sense of the maturity of the underlying portfolio for any fund. This is a good metric, but certainly cannot be the only parameter to check before investing. There can be holdings with short duration, but actual repayment may suffer during a crisis; this does not come up in the Average Maturity of the portfolio.

Quality of portfolio is significant in any investment and in the case of debt its relevance is even more. Companies and institutions to whom debt funds lend investors’ money show the quality standards of the portfolio. Better the companies, lower the risk. Many funds invest in government-backed PSUs, public financial institutions, and other high-quality institutions; investors started preferring such funds as they realize it is better to be safe than sorry.

Debt funds lending to private companies that offer additional returns after their due diligence will generate additional returns for its investors, but now investors have started asking the question of whether they would like to take this risk for additional returns based on the quality of the portfolio.

Sebi has also stepped in to avoid a similar crisis in the future. The recent changes like riskometer for each fund need to be defined, calculated, and published will help investors to understand the risk on any fund in a much better manner. The scoring mechanism for the new viscometer in debt funds based on Credit Risk, Interest Risk, and Liquidity Risk will be a useful tool to decide the kind of fund to invest.

The usual practice of funds indicating risk based on its category and duration in the present riskometer didn’t help investors, but with the new riskometer, there is a high possibility that risk indicators for funds within the same category would differ. This will share more insights about the funds and risks associated with them.

The episodes of debt funds disappointing investors from a risk mitigation perspective in the last couple of years have made fund management, regulators, and investors more vigilant. Fund houses continue to offer different debt funds for different purposes and risks associated with it. And investors continue to invest in them. However, they no longer think that debt funds are risk-free and returns are the only criteria to invest in these funds.

Investors today want to know more about different debt funds and their risks before investing. The approach of investors towards debt fund investing have changed, they are more cautious and informed before investing.

(Harshad Chetanwala is the Founder of My Wealth Growth, a wealth management firm based in Mumbai.)

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