Are debt MFs worth your money? A reckoner

As debt funds land in trouble following multiple defaults and downgrades by bond issuers, ET Wealth addresses some key questions from worried investors.1. Why are debt funds in bad shape?Trouble started with the IL&FS fiasco, where a default and subsequent rating downgrade adversely affected several mutual funds holding its bonds. The problem has now spread to other entities such as DHFL, Essel Group, Yes Bank and Reliance Anil Dhirubhai Ambani Group. While many of the instruments were rated AAA or equivalent at the time of investment, the derating has eroded their worth. Debt schemes have had to mark down the value of affected securities. Some fund houses had lent against shares held by promoters. With share prices of these firms crashing, the value of the collateral eroded sharply. Some fund houses have invoked the pledge and sold shares to recover value. Others have chosen to either roll over maturity date of fixed maturity plans or allowed part redemption.2. Why is the AUM of some debt funds falling sharply? What does it imply?Credit events eroding the NAV of debt funds are not the only problem. Investors have been rushing for the exit door at the first sign of trouble. With high redemptions, the asset base of some debt schemes has eroded sharply. AMFI data says outflows from debt funds shot up to Rs 1.25 lakh crore in 2018-19 against Rs 9,128 crore a year ago. When faced with such high redemptions, fund managers can only arrange for the money in a short time by selling the more liquid, better quality instruments in the fund portfolio. In several cases, this artificially increases the fund’s exposure to troubled or low-rated instruments as a proportion to the overall portfolio. This heightens the risk profile of these debt funds even further.3. Why are some debt schemes being merged?When the proportion of risky bonds rises beyond comfort levels in debt schemes, it no longer remains viable to continue operations. DHFL Pramerica AMC merged two of its open-ended schemes with heavy exposure to bad bonds with two of its larger schemes. DHFL Pramerica Floating Rate Fund will be merged with DHFL Pramerica Ultra Short Term Fund while DHFL Pramerica Medium Term Fund is being merged with DHFL Pramerica Credit Risk. More such mergers could be in the offing if the AUM declines further. While such mergers are good for smaller schemes, it is not healthy for larger scheme which inherits the debt. It may leave investors exposed to a risk they didn’t sign up for.4. Some debt funds are resorting to side-pocketing. How does this help me?Apart from scheme mergers, DHFL Pramerica has created side-pockets in two FMPs—DHFL Pramerica Fixed Duration Series AH and Series AP. Side-pocketing allows a fund to carve out a section of its holdings into a separate scheme. By segregating risky assets from the rest of the portfolio, the scheme can better protect its healthy assets (existing investors will not redeem). The units in the side-pocket can be redeemed only when recovery is made and existing investors can benefit from any recovery. Meanwhile, the main scheme continues to operate as before. While side-pocketing protects value in the healthy part of the fund, it is akin to sticking a plaster. Availability of a backstop may also encourage adventurism by some fund managers. 5. Should I stay away from debt funds for now?This is not the first time credit events have hurt debt funds. The impact is more visible now because the funds have become big. Also, multiple developments have happened in quick succession. A chunk of these are in the form of rating downgrades rather than credit default. This is more a temporary cyclical phenomenon.Barring that, debt funds remain a reasonably safe avenue for parking short-term money. Investors need to identify and invest in a fund more suitable to their risk profile and horizon. Do not hunt for higher returns. The extra risk you take on is not worth that higher yield you crave. Stick to safety of funds biased towards AAA or equivalent rated securities. Given the diversified nature of holdings in most debt funds, one or two instances of default will not dent your return.6. I was told debt funds are risk-free. Aren’t there any zero-risk debt funds?Contrary to popular perception, debt funds are not risk-free investments. Every debt scheme is exposed to risk in some form. Some funds may carry interest rate risk, a few are exposed to credit risk while others are exposed to both in different degrees. The least risky debt funds are overnight funds, which have negligible interest rate risk and are nearly immune to credit risk. Liquid funds and ultra-short term funds are reasonably safe, yet cannot be considered risk-free. Credit risk funds and all long duration funds including gilt funds and dynamic bond funds are much more prone to risk.

from Economic Times http://bit.ly/314N7t5