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Most important risk lesson for debt fund investors

DHFL had borrowed from a number of mutual funds, who placed these bonds in their various debt fund schemes. When DHFL failed to pay the dues, the value of these bonds had to be written down, which in turn meant losses for debt fund investors.

News portals are buzzing with the first ever move by the RBI to take control of the functioning of a non-banking finance firm, namely – DHFL, with the purpose of a resolution towards insolvency or bankruptcy.

What does this mean? 

Effectively, RBI will now control the operations at the defaulting NBFC and start the insolvency process through its appointed administrator. 

Why does this matter? 

DHFL had borrowed from a number of mutual funds, who placed these bonds in their various debt fund schemes. When DHFL failed to pay the dues, the value of these bonds had to be written down, which in turn meant losses for debt fund investors. 

With RBI taking over, there is an expectation that the process of recovery will be better managed albeit in a more time-consuming manner. 

In general, the idea behind an allocation to debt funds is for stable returns and in some cases even regular income. DHFL was not the only defaulting company in bond portfolios last year; several high-profile lenders fell by the way causing pain to debt fund portfolios. 

Consequences for the investor

In general, the idea behind an allocation to debt funds is for stable returns and in some cases even regular income. DHFL was not the only defaulting company in bond portfolios last year; several high-profile lenders fell by the way causing pain to debt fund portfolios. 

As the fixed income market credit and liquidity cycle took a turn for the worse, things got ugly fast. It would have been hard even for fund managers to anticipate this kind of repayment crisis in the bond market. You trusted the fund manager, who trusted the ratings and the stable market mechanism – but all failed. However, the consequences are largely borne by you as the investor who loses out on return. 

How does having a large number of instruments within the portfolio help?

Let’s assume that a debt fund portfolio has Rs 100 invested across 10 bonds, which means 10% in each. This portfolio has an expected yield of 8% per year. Assuming zero expenses to keep things simple, at the end of a year the scheme should be able to return Rs 8 (in total) or the total value of the fund should be Rs 108. 

If one bond which also has a yield of 8% per year defaults, the fund returns are in big trouble. Not only will the annual interest payment not get added to the fund returns, but also the principal value invested in the bond has to be written off in the worst-case scenario. Let’s say the default happens after six months when the current value of the scheme stands at Rs 104. Immediately, thanks to the write off in principal value the scheme returns will show a single day 10% fall! 

If you remain invested for the entire year – some of the shortfall will get made up with interest accumulated on the other nine bonds; but, even at the end of the year you will lose capital and get back only Rs 97.6.

Now let’s assume the same fund, but with 30 bonds instead of just 10. All other things remaining the same, if one bond defaults after 6 months and you remain invested till the end of the year – you still come home with a positive 3.84% return. 

This is how a diversified portfolio automatically manages the risk of default

What is the lesson to be learnt? 

In one word – diversification. 

It’s often difficult to predict such extreme market cycles in advance. Your only safeguard is choosing adequately diversified portfolios and also diversifying your debt fund exposure in more than just one scheme rather than relying on the expertise of just one fund manager.

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