New Debt Mutual Fund Norms Kick In: Here's What Should Be On Investors' Watchlist

The introduction of credit risk-based single issuer limits for investments by active debt mutual funds has brought about a level-playing field for both active as well as passive funds.

This might look like a small step to align the single issuer investment limits for all types of debt funds, but its effect will be seen over a period of time.

Investors with exposure to debt funds will witness an impact on the portfolio of some of their holdings as these are implemented.

Here are the main areas where it will play out:

The change that has been proposed by the Securities and Exchange Board of India states that a mutual fund scheme shall not invest more than 10% of its Net Asset Value in debt and money market securities rated AAA by a single issuer.

Similarly, it will not invest more than 8% of the NAV in debt and money market securities rated AA by a single issuer and not more than 6% of its NAV in debt and money market securities rated A by a single issuer.

These limits can be extended by 2% of the NAV, with prior approval of the Board of Trustees and Board of Directors of the asset management company.

This, in effect, puts a limit that decreases in quantum as the credit rating of the issuer goes down.

A lay investor might not be able to monitor the portfolio of a debt fund in great detail. The most common thing that they do is look at returns, while considering a fund for inclusion in their portfolio.

This approach has a higher element of risk because the manner in which the fund manager is increasing the returns in the fund is not considered. Many times, the higher return comes due to slightly lower quality paper in the portfolio. This has come back to haunt investors in many cases, when several companies defaulted—resulting in a hit on the NAV and negative returns—even in funds considered relatively safe by investors.

The new limits are not applicable for credit risk funds, so this point has to be specifically considered, because credit risk funds try and generate higher returns by taking a higher credit risk and investing in slightly lower quality debt instruments.

Investors going towards these funds should realise that the risk here remains higher.

On the other hand, for other debt funds, the restrictions of exposure for a single entity will mean that automatically lower quality paper will have a lower exposure. So, even if an entity defaults, the impact will be restricted due to lower exposure.

The other point is that for existing schemes, there is a grandfathering clause, so the current holdings can be held till they mature and the guidelines will apply only for the consequent new purchases.

This could mean that the effect can take some time to slowly trickle down to the whole portfolio for existing funds.

It is not only the equity space where passive funds are making their mark, as these have started to slowly gain the attention of both fund houses and investors in the debt space too. These guidelines are already applicable for passive funds. So, their extension to active funds in the debt space brings them on an equal footing.

As the impact of this is felt on the portfolio of active funds, over a period of time, it will also be a challenge for debt fund managers to consistently outperform the passive funds. This will bring an increased focus on the fund manager, because they would have to generate the extra returns or alpha for the higher cost that their schemes are charging.

This will also lead to a situation where the fund manager will have to delicately balance the risk that they are taking with the returns that they want to generate.

Excessive focus on just controlling the risk could have an impact on the returns and this is what investors would want to watch closely.  

Arnav Pandya is founder, Moneyeduschool.