Most large corporates already use debt funds to manage their surplus funds efficiently. Given the tax advantages, we believe individual long term investors will increasingly view debt funds as a viable alternative to bank FDs.
Based on our discussions with customers, the main factor holding back debt mutual funds is investor’s comfort with the credit risk being taken by debt funds.
Note that the debt fund carries 2 kinds of risks
- Interest rate risk and
- Credit risk
In this article, we will be focusing only on credit risk.What is Credit Risk?
A debt mutual fund essentially collects money from investors, and invests the same in a debt instrument of either a government bond, bank, or a bond issued by a Company.
- In the event it is a government bond, it has a sovereign guarantee, and it is considered to be safest (even safer than a bank fixed deposit which is guaranteed only to the extent of Rs 1 lac)
- At the next level, are the nearly AAA entities like Bank certificate of deposits, bonds of AAA Public Sector units like NTPC, IOC, etc or other AAA rated companies in India. These instruments are considered very safe carrying a quasi-government guarantee in many cases
- The level of risks continues to go up on in a rating scale of AAA, AA, A, etc with AAA being the safest and A being riskier
Assume the debt mutual fund has invested in the debt instrument by say a high risk company, like SpiceJet. Given the current problems the company is facing, the debt fund would unlikely get interest or the principal back in the worst case. Debt markets would ensure the bond is traded at a value that is far less than its par value. The risk to interest or the capital is called credit risk.
The global crisis in 2008 was led by massive credit defaults in mortgage debt globally and in the process many debt funds globally lost money. A few years ago, Greece government bonds ran the risk of default, and currently many oil dependent countries run the risk of defaults.
Managing your debt fund portfolio
As an investor who is looking at debt funds as a material alternative to fixed deposit, it is important you know what level of risk your debt fund is taking, to deliver the returns that you expect from the funds.
Just because the fund has delivered reasonable returns in the past does not mean, it would continue to do so. Returns going forward is partly based on the level of credit risk the fund is taking to achieve the results.
Presenting the analysis we did
In order to address this question, we, the research team at Scripbox decided to check the spectrum of risk various debt funds are taking. In order to do so, we selected an assortment of 213 debt funds which have more than 500 cr of assets under management (larger funds) and been around for more than 5 years (seasoned funds).
We then evaluated the blended credit risk being carried by each of these funds, based on a weighted average Credit Rating on the instruments that these funds have invested. We then assigned them scores with 1000 as the highest to Government bonds.
Result of our analysis
The result of our analysis surprised us.
- Of the 213 funds that we analysed, the weighted average rolling credit scores ranged between 695 – 989
- Only 72 funds, of the 213, satisfied the test of having Credit Risk equal to, or better than a Fixed Deposit (~900)
- More importantly, this is an analysis that the investor can do on a monthly basis, as portfolio disclosures have moved from quarterly disclosures to monthly disclosures.
- At Scripbox, we have developed a proprietary methodology, to not only check funds for the credit risk they take, but also to monitor it on a monthly basis
- Debt funds are a better substitute to a fixed deposit, due to
- Tax advantage for holding more than 3 years
- Daily liquidity, if required in emergency situations
- Less paperwork due to TDS, etc
- On the other hand, one needs to follow the Credit Risk the fund takes to deliver the returns that you expect it to.
Debt investing is a place to park your hard earned money to ensure capital protection. You don’t want to be taking on credit risk for that component of your investment – may as well invest in equities, if you want to take the risk, as risk adjusted returns are far higher.
We can firmly conclude that one should be investing wisely only in those debt funds that manage credit risk well.