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Debt Fund Default: What Should I Know and Do?

After the recent incident of some investors suffering losses in debt funds, all investors are naturally concerned. In this article, we analyse the incident and explain what you should do.

After the recent incident of some investors suffering losses in debt funds, all investors are naturally concerned. In this article, we analyse the incident and explain what you should do.

This incident has brought into focus the role of Credit Risk in debt/ liquid funds. So far, this was not considered material, as India has not seen any major impact on debt funds due to credit risk.

What really happened?

JP Morgan Short Term India income fund and the JPM India Treasury Fund had invested significant amounts in bonds of Amtek Auto. The rating agency suspended the credit rating of Amtek Auto (indicating risk of default). As per regulatory norms, the fund had to immediately lower the value of these holdings in its books. Since these bonds comprised a large portion of the funds’ entire portfolio, the NAV of the funds fell about 2.5-3% each reflecting the potential for loss to be suffered by the fund.

I didn’t know this could happen

You are not the only one. To understand this you must recognize that all debt investments (including FDs) are, in a way, a loan given to the other party. The risk that the loan won’t be repaid is usually low but always there. This risk is measured by credit ratings assigned to each investment. A good credit rating means lower risk and therefore, usually, a lower interest rate.

A debt fund will usually invest in many such bonds with varying credit ratings. A good fund manager will achieve high return with a high average credit rating. A poor fund manager will take big risks by investing your money in poor credit bonds.

So what went wrong in this case?

  1. There was a sudden decline in the credit rating of the bond due to financial difficulties at the issuing company.
  2. It appears that these funds, which were relatively small funds, invested a large portion of their corpus in a single company’s bonds. This is called concentration risk (too much money exposed to a single risk).
  3. Most investors, unaware of the fundamentals of debt funds investing, invested in these funds without due evaluation of the risk being taken by the fund.

What went right?

Incredible as it may seem, the incident reveals a lot of positives as well.

  1. Transparency: The fund, as per regulatory norms, made immediate disclosure and reflected the anticipated (not even actual) decline in its NAV.
  2. Diversification: Investors, even though they lost some money, could have lost a lot more money if they had invested in the bonds directly. By investing through a MF, the risk was diversified and the investor did not lose a material portion of their investment.
  3. As of now, there does not appear to be any appearance of mala fide intent. The fund was taken by surprise by the sudden negative change in the company’s credit rating.
  4. The regulatory oversight kicked in immediately with SEBI stepping in.

What can a debt fund investor do to protect themselves from this risk?

To guide your choice of debt funds, the following should help you:

  1. Evaluate Credit Risk: Don’t evaluate funds by pure performance, but also evaluate credit risk carried by debt funds
  • Funds are required to disclose their investments along with their credit ratings every month
  • The data is available to evaluate credit risk
  1. Concentration Risk: Watch out for the fund taking a very large exposure to a single company/issuer. This can be determined from the same data.
  2. Consider the size and longevity of the funds
  • Since debt funds need to invest quite large amounts in specific instruments, the larger funds have an advantage over smaller funds to manage both credit & concentration risk
  • Look for funds with proven track record of risk management

With over 3400 debt funds across multiple schemes / types, calculating and monitoring the underlying credit risks of all these funds, to arrive at your selection, can be a complex exercise.

How can we help you at Scripbox?

Our selection algorithm recognizes credit risk as a very important parameter. The aim of our portfolio is: “to optimise medium term returns in the debt market, with a risk that is almost comparable to FDs.”

To achieve this:

  1. We review the history of the blended risk taken by the fund and give it a credit score. This has the largest weightage in our selection.
  2. We eliminate funds below a certain threshold of blended credit score.
  3. In addition we filter out small funds to mitigate concentration risk.

Why should investors use debt or liquid funds at all?

Investors have a choice between Debt Funds, Bank Fixed deposits or investing directly in company deposits/bonds. The benefits of debt funds have been explained at length in the past.

To summarize

  1. Debt funds are highly liquid. You can typically get your money within a day or two directly into your bank account with minimal paper work.
  2. No minimum ticket size to add or withdraw from your debt / liquid fund schemes
  3. Taxation only at the time of selling, compared to FDs where interest is taxed every year. If you hold a debt fund for more than 3 years, you get indexation benefit further reducing your tax.
  4. Even for shorter term holdings, liquid funds can earn a higher rate of interest

For the above reasons, debt and liquid funds are here to stay. One isolated incident cannot take away the advantage of these funds for investors..

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