Traffic jams in Mumbai are normal but I recently saw a picture of a traffic jam (queue) to climb and descend Mount Everest. The sad part was that a few climbers died as they ran out of oxygen when descending. Climbing Everest is not just about reaching the summit, the journey doesn’t end till you return to the base camp as the descent is equally difficult. Credit issues facing debt funds, especially credit risk funds (CRFs), have a strong connect with this example as many investors entered CRFs for higher returns vis-à-vis traditional deposits. They thought it was a one-way street, unaware of the downside risks like defaults or downgrades which impacted returns recently.
The key risks associated with debt funds include interest rate risk, credit risk and liquidity risk. Interest rate risk is triggered due to change in interest rates which generally has an inverse correlation to returns. Credit risk impacts returns due to default or delay in paying interest or principal by the issuing company, or by a downgrade in credit rating. Liquidity risk occurs when a fund is not able to liquidate its investments at fair valuations owing to limited trading volumes (typically, impacts lower-rated securities). Recent credit events related to non-banking finance companies (NBFCs) and housing finance companies (HFCs) have put a focus on credit and liquidity risks.
Though we have seen such events earlier, the current situation has been more intense, as downgrades or defaults have happened in quick succession. While the belief is that only lower-rated papers and CRFs have been hit, the reality is that this has happened across ratings and fund categories. CRFs, however, were singled out—one, because of the word “risk" in their names and two, because by definition they invest 65% or more of their assets in below-the-highest-rated securities and are, therefore, believed to take higher credit risk. Commensurately, CRFs also have the potential to provide higher returns which increased their popularity over the years. Their assets under management (AUM) grew by 51% per annum since their inception in 2002 to ₹80,000 crore as of April 2019. Investors must, however, remember that credit risk is not restricted to CRFs but is present in every fund that invests in corporate credit.
What should investors do in this situation? Firstly, avoid panic and consult a financial adviser. An exit may be the last resort as you can lose due to exit load, capital gains and any loss on the investment itself. It is often better to remain invested and allow returns to improve via accruals, rather than exit at a loss. This, however, will depend on the concentration of securities in the portfolio, besides the track record of the fund house and portfolio manager in managing such credit events. Staying invested may also allow investors to gain from any potential upside if recovery happens and any money is returned to the fund.
Can credit events recur? Yes. Upgrades, downgrades, or defaults depend upon the company’s business position, sectoral outlook, etc., and are a part and parcel of investing in debt funds (like market volatility in equity funds). Debt funds are not guaranteed but market-linked—they aim to maximize returns by buying corporate bonds vis-à-vis government bonds for better yields; buying AA- and A- rated bonds to gain from their higher yields and increasing or decreasing portfolio maturity to benefit from a rise or fall in interest rates. One may lose if these calls go wrong, but the impact may often only be transient. Investors wishing to benefit from the potential for higher returns must be resilient, understand the risks, and learn to mitigate these. A bigger solace is that even CRFs, which are believed to have higher risk have not delivered negative returns over any three- or five-year periods in the 15 years till April 2019, besides outperforming corporate bond funds.
How to mitigate credit risk? Diversification can help lessen the impact of a default or downgrade. For example, if a portfolio has 50 securities, then each security only has a 2% weight in the portfolio (if equally divided). The impact of default in one security is thus limited. According to CRISIL, even A-rated securities have only about 2% chance of default (three-year holding period), indicating that 98% of A-rated securities may not default. Thus, a well-diversified portfolio coupled with the manager’s track record can help mitigate credit risk.
Also, corporate bonds are relatively illiquid owing to which fund managers often adopt a “buy and hold" approach. Therefore, even in case of a near-term downgrade, they may believe that the security will recover and provide capital appreciation. Hence, it is important to identify fund houses and managers with strong risk management processes and consistency in returns despite defaults and downgrades. On the other hand, those lacking the risk appetite for such events can look at funds like banking and PSU, overnight, liquid and money market funds which often have shorter durations and lower exposure to corporate credits.
Remember that the best view comes only after the hardest climb. Accordingly, difficult debt markets are often the best time to find yields, but they are also the most difficult time to convince investors to buy.
Sanjay Sapre is president, Franklin Templeton – India