Can You Ignore Default And Liquidity Risk While Investing In Debt Mutual Funds?

Jan 9, 2019

The Capital market regulator has been nudging mutual funds to focus on the quality of portfolios ever since mutual funds have started investing aggressively in low-rated debt instruments.

The capital market regulation issued reclassification norms to make investors aware of the risk elements and to instil portfolio discipline among mutual fund houses.

Yet, the fiasco of the IL&FS default sent shivers down the spines of investors when even liquid funds posted losses on account of their concentrated exposure to defaulting subsidiaries of IL&FS.

[Read: How IL&FS Rating Downgrade Will Impact Your Mutual Funds]

Since then the word through the grapevine has been that Capital market regulator might issue a short-term locking period for mutual fund investors. Economic Times dated November 12, 2018, carried a story on this topic.

There's no smoke without fire, indeed!

Mr Arvind Chari, head of fixed-income and alternatives at Quantum Advisors, had expressed a quite comprehensive view:

• "At Quantum, we believe that Liquid Funds should not take credit risks so as to ensure that it meets the true objective of keeping it safe and liquid. We do not know what Capital market regulator is likely to propose for liquid funds and we have to wait and watch, but I don't think putting restrictions on redemptions is a good idea. Capital market regulator should propose that all assets are fully marked to market to ensure that the declared NAV is 'real'. It should also consider mandating that liquid funds do not take credit risks."

The Financial Stability Report published by the Reserve Bank of India (RBI) made a crisp comment in this regard. Below are the excerpts from the report.

• It might be appropriate to consider investor level concentration limit on issuer to ensure diversification at issuer level. To improve liquidity in money market and liquid funds, valuation and maturity restrictions are under review by Capital market regulator. A mandatory liquidity limit may also be considered by them. In this regard, an effective ALM regime in non-banking financial sector may also enhance systemic resilience.

If you read carefully, RBI has been advising the industry to stick to the basics of investing.

You must have heard umpteen times that diversification is the essence of portfolio management!

Those who aren't well versed with the basics of investment management, diversification simply means not putting all your eggs in one basket. It's not only important for you to diversify across various asset classes such as equity and debt, but also within each asset class. For example, when you are investing in fixed income assets, you may consider fixed deposits, debt mutual funds, and company deposits among others.

Similarly, a debt fund diversifies its portfolio across various securities, (maturities and the yield curve) depending on the objectives of the schemes.

But what about the issuer of debt instruments?

As you might remember, DSP Mutual Fund sold DHFL's commercial paper in the secondary market at a steep discount. This happened primarily because of illiquidity in the secondary market for such instruments. However, had it formed a significant portion of the outstanding debt of DHFL, it would have created a major problem for the company. Not only did it affect all future bond sales, but this would also affect its borrowing costs significantly for the papers with similar maturities.

[Read- DSP Mutual Fund's Sale of DHFL Bonds: Here's What You Need to Know]

Since mutual funds have become an important source of funding to some industries including Non-Banking Finance Companies (NBFCs), it's important to ensure that issuers of credit instruments aren't over-relying on one source.

We expect IL&FS and DHFL episodes to serve as lessons to learn since they were a result of systematic failure. Capital market regulator might take additional corrective measures so that the hard-earned money of small investors is not at risk in the future.

That said, even fund houses need to have proper due diligence and internal risk assessment policies in place to avoid taking exposure in such groups and must not rely completely on ratings that rating agencies provide.

It remains to be seen if Capital market regulator introduces liquidity limits for liquid funds or redemption restrictions for investors or both. In any case, investors need to be careful while investing even in liquid funds.

You shouldn't just look at the past returns, but you also need to analyse portfolio trends, risk preferences of the fund house, the robustness of investment processes and systems of the fund house, and the expense ratio among others.

Liquid funds could help be a useful avenue to park your short-term surplus, but don't assume that liquid funds are safe.

[Read: Why Your Money In Liquid Funds Is At Risk]

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Author: PersonalFN Content & Research Team

This article first appeared on PersonalFN here.

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