Debt Funds – Stranger And Beyond Stranger Things
With apologies to the Netflix original sci-fi horror series, whose creators are the super duo – popularly known as ‘Duffer Brothers’ but that, is totally incidental.
Let me start by telling you a story, a deeply personal account:
In 2009-10, a certain business head of a fixed income-focused asset management company had thumped on the table and declared that the 10-year government security yield will reach 4.5 percent – that was his view. We were already at 5.5 percent or thereabouts. The financial crisis in 2008 has just gone by and there was some understanding of the risk in fixed income/debt funds – or so we thought.
Here is how the 10-year chart looked, soon after:
I lost money for my clients. Naturally.
My sorrow knew no bounds. I decided that from then, I wanted to treat debt funds with more caution.
Through years of asset allocation training, one thing was clearly learnt.
While one is making a portfolio, if one takes risk, (as one always does, given the jingoism we exhibit around Indian equities), that risk needs to be diversified away, as much as possible. Hence avoiding debt funds altogether was not a preferred option.
On top of that, the lure of saving taxes by indexation (adjusting the purchase price to inflation) was too much to resist. Clients were demanding fixed maturity plans. I lost an important client because I tried to explain a credit rating to him. He was upset that I only offered funds that had lower ‘indicative yields’ and I thought that was really strange. I was counseled by my seniors that my manner of trying to coach the client wasn’t right. That is a lesson that has stayed with me.
It is a different matter that, SEBI banned the practice of declaring indicative yields and indicative portfolios soon after. The wealth management community, as we always do, stuck to the rule book.
It took me some time to recommend debt funds again – certain debt funds in particular.
In the recent past, a few peers and l, have openly aired our blanket disapproval of ‘credit risk funds’ even before they were called so. Not because we thought we were infinitely superior in our knowledge levels – in fact, quite the opposite.
Once, when we sat to brainstorm on a Franklin ‘Credit Opportunities’ portfolio, we couldn’t recognise most of the names. Of course, when we wrote in, they explained that most were papers of subsidiaries of companies we did know, structured obligations, pass-through certificates, special purpose vehicles. Now we knew for sure that we didn’t know.
So, some of us chose to err on the side of caution, and from the ‘approved list’ of funds in our organisation picked up the ones called short and medium term – with lesser duration and higher credit rating. The product teams would have obviously done their research while creating the ‘approved list’ and that was to mean that the ‘due diligence’ was already done. The boss said, there was ‘collective wisdom’ which ought to be better than an individual’s discretion. Fine line, that one, etched in my mind forever.
The funds we chose, in common parlance, were called ‘accrual’ funds – to be understood as ‘accruing’ income if all the investor exhibited was patience.
Here is an example of an ‘investment objective’ of one such scheme – “to generate regular income and capital appreciation by predominantly investing in a portfolio of debt securities with medium-term maturity”. Some of these funds were almost 100 percent AAA and we had repeatedly checked with the fund houses if they were sticking to the mandate. Oh well - this time, the credit rating agencies got it wrong too.
Occasionally, I recommended dynamic funds (of course, from the approved list), if I was impressed by some presentation slide on how dynamism was displayed on several occasions. Sometimes, I would be impressed by the fund manager’s passionate speech on what he thought the RBI should be doing, never mind what the RBI actually did! Dismal performance, yet again!
Before I launch into the current credit situation, let me first tell you that some investors, indeed understand what credit risk is, and are willing to work with the fund manager and wait for recoveries in the case of a liquidity event.
In many such cases, they have been rewarded after the storm passed. But these clients are not many in number so I thought I would end up disappointing lesser number of people and life went on just fine – until it didn’t.
When the current credit situation broke out, things just got stranger. We spooled data on toxic assets, there were troubled papers in ‘medium term plans’, ‘short term plans’, ‘dynamic funds’, even debt portions of some balanced funds! I mean, they obviously didn’t suddenly get there, they were just discovered.
Time For Action?
I am a decade older now and hopefully wiser so I did my analysis in the following way:
All right, the crediting rating agencies got it wrong, but what about the internal processes of the fund house? After all, if the weightage in each entity was rationally done, even in the event of a default and a markdown, how much damage could possibly happen?
In closed-ended funds, the urgency of action is not on you, the fund house recognises the default, devises some way of going about it and you are mostly a bystander. In open-ended funds, it is a little bit complicated.
By construct, open-ended debt funds have papers of different maturities, so even if you stare at a ‘percentage exposure’ to a paper, that is not sufficient information.
Also, you can’t just assume that a paper is going to default. Even your fund manager cannot – she/he has to recognise the default when the event of default actually happens. It cannot be done pre-facto. This is as per the SEBI circular cited here.
Also, these markdowns may not be permanent losses. If there is a recovery, as explained earlier, the money can come back if you have the holding power. You can read this comforting note from Reliance Mutual Fund to soothe your nerves. You may still have questions around why, as a balanced fund holder, you have to live with a 3 percent markdown but these are unprecedented times.
So what are your options?
• You could seek redemption:
The fund manager is obligated to use cash holdings, sell holdings that can be liquidated and return your cash. If the fund is able to recover some of the ‘delayed’ (also called default, in financial parlance) assets – like Aditya Birla Sun Life may be able to in the case of the IL&FS SPV for Jharkhand Infrastructure Implementation Co. Ltd, the temporary haircut may be reversed and the net asset value will jump up. You will miss that reversal. But you will be calmer now, it is all about nerves. You have to choose.
• You could do nothing:
If you don’t, you may be left with a greater percentage of the toxic holdings – as has happened with UTI debt funds.
The regulator allows a fund to buy only 10 percent of a paper in any entity and take it up to 12 percent with board approval.
Here is UTI’s Banking and PSU Debt Fund portfolio as on Aug. 31, 2018. I doubt if I would have jumped if I saw this.
The same Jorabat Shillong Express Highway, is now 16.42 percent in UTI Banking and PSU Debt Fund and it had to recently take close to a 7 percent markdown. Why? Because some people exercised their option to redeem and brought the AUM figure to Rs 265 crore, on March 31, 2019.
Now, the million dollar question – which to exit and which to hold? In order to make this decision, one will have to understand each defaulting entity and that can be quite a task. Take a look at this article, which talks of 22 subsidiaries out of 173 being fully solvent and this is just one single entity - IL&FS.
In case, the holding period of three years has not been completed, I have personally found counselling clients to exit and pay 30 percent taxes on short term capital gains, rather difficult. Yet it needed to be done in some cases. Ask your advisor for handholding and if you are a do-it-yourself investor, then go ahead, DIY!
I conclude by saying that life with debt funds has gone from stranger to beyond stranger. And, there are ‘duffer’ brothers and sisters among us as well and this time, I mean the word quite literally.
Abaneeta Chakraborty has close to two decades of experience in managing money for UHNI families. She founded the firm Abanwill Consultants LLP in 2017 to provide independent views on investing.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.