Be aware of the risks that debt funds face

The mutual fund (MF) industry and investors alike were rattled earlier in August this year when the sharp downgrade in Amtek Auto Ltd bonds, a AA-rated security, to C led to a sharp fall in the net asset value of JPMorgan's India Treasury Fund and India Short Term Income Fund.

Two things happened. First, short-term bond and treasury funds are perceived to be relatively less risky and a single-day fall of nearly 4% and 1.5%, respectively, came as a shock. Second, the downgrade of the Amtek Auto bond cast a shadow on other lower-rated bonds held by other schemes, and investors began to question whether there were more such falls in the offing. The latter was more a result of fear psychosis, so, we will focus on the former-risk perception in a debt MF.

The actual risk in a debt fund can be different from the perceived risk. The perception is a result of the category the fund belongs to, how it is named and the benchmark that it is compared against-hence, a result of the positioning. But the actual risk the scheme carries will be a result of security selection. For comprehensive long-term management of personal finances, debt funds can't be ignored. But you need to understand their risks better so that your fund selection is more effective. Let's look at the various types of risks in a debt fund and how you can identify them.

Interest rate risk

Interest rate risk is present in all debt portfolios, but the degree varies. For example, while gilt funds carry very high interest rate risk, in money market funds like liquid funds and ultra short-term funds, it's close to negligible.

Here is how you can tell. Interest rate risk as measured by duration shows how much bond prices react to changes in interest rates. This type of risk is mostly market-linked and is defined by the maturity profile of the bond. Longer the tenure or further the maturity of a bond, higher is the interest rate risk.

Bond prices are inversely related to interest rates; when rates fall, prices rise, and vice versa. Let's say, interest rates in the economy head higher. In such a case, bonds issued earlier with a lower coupon get less attractive and longer the maturity of the bond, the less desirable it is. So, price falls sharply in line with the maturity profile. Opposite is also relevant ; if interest rates fall, longer-tenure bonds benefit the most.

For most bond funds, interest rate risk is a priority; this is true across different types of products, be it insurance-linked funds or MFs. Arun Srinivasan, fund manager-fixed income, ICICI Prudential Life Insurance Co. Ltd, said, "For our clients, stability of returns is important. Hence, managing interest rate risk in the portfolio is paramount." Unlike MFs, with insurance products, investors themselves may not be able to manage this by choosing funds of different durations.

If you invest in debt funds, aligning your own investment horizon with that of a fund might help to mitigate the interest rate risk. Sudhir Agrawal, fund manager, fixed income, UTI Asset Management Co. Ltd, said, "One can manage the interest rate risk by matching their investment time period as closely as possible with the average maturity of the fund portfolio. Closed-end funds like fixed maturity plans best address this need." For a closed-end fund, the average maturity is fixed. So, the risk is neutralised in such funds.

In case of open-ended funds, it can be trickier because average maturities can vary. Let's say, a short-term income fund has an average maturity of 12-18 months. Then your own investment horizon can be 9-12 months. But there is no scientific way to determine this.

Regulations do not allow money market funds such as liquid funds to hold securities that have a maturity of more than 60 days. This makes them significantly less vulnerable to changes in general rates and investors can be assured that in the absence of any extraordinary circumstances (think Lehman collapse in 2008), returns earned will be more or less equal to the portfolio yield.

Credit risk

Bonds are assigned a credit rating based on their ability to finance debt obligations and their cash flows. Basically, investing in corporate bonds carries a binary risk-either you get your money back or you don't. The latter is default-the risk of non-payment of interest; and if the situation worsens, then non-payment of the principal amount. The probability of this happening is defined through credit rating.

This is done through registered and licenced rating agencies. A bond with a AAA equivalent rating is considered of the highest quality with negligible risk on default on payment of interest and repayment. The rating ladder then moves lower to AA, A, BBB, BB and so on. Despite its duration, a debt portfolio, typically, has a mix of bonds with different ratings but the mix varies depending on the type of fund.

So, why would anyone invest in anything other than the highest rated bonds? The answer is to get higher returns. Agrawal said, "In the long run, investors seek portfolio returns that are higher than the risk-free rate, and for that to happen, a mix of high yield funds becomes an integral part of the portfolio."

The lack of a very high rating like AAA is compensated by a higher coupon on the bond. Hence, if you invest in, say, a bond that is rated A, you are likely to get a interest coupon that is 200-300 basis points (bps) higher than what you would get for a AAA-rated bond. One basis point is one-hundredth of a percentage point.

The difference in interest rates across bonds of varying ratings depends also on the demand and the interest rate environment. This can change from time to time, but essentially you will always earn more by holding a lower-rated bond.

This is how the risk can unfold. Rating agencies typically downgrade a bond when there is deterioration in financial abilities. But this usually happens one step at a time. Sometimes, as was the case with Amtek Auto, the rating gets downgraded from AA (a relatively high probability of repayment) to C.

D. Ravishankar, founder director, Brickworks ratings, said, "Rating downgrades take place either due to a gradual deterioration of the financial performance of the company or due to liquidity risk. The former may not result in a sudden downgrade. But if there is even a temporary liquidity crisis, the company could face steep rating downgrade when the event occurs. So, a highly-rated bond that hasn't been able to refinance its obligation can go to C or D rating in a matter of days."

Such downgrades will lead to an immediate loss in asset value for the investor and eventually, unless the company pays up, you may be forced to accept a total loss. This is the risk and it can play out in portfolios that hold lower-rated securities.

Although it is good for the portfolio to have some bonds that are below the highest credit of AAA, if you are interested in maximising returns through lowcredit bonds, you should be willing to take on the higher risk.

Corporate bond portfolios with lower ratings can also be used to give stable accrual returns through the coupon. In these, quality of the issuer matters and fund managers consider other things apart from ratings. But there are no guarantees.

Srinivasan said, "We put safety first. Hence, at least 75% of the debt holdings are AAA and equivalent rated. For anything below that, we analyse the underlying business and cash flow of the entity apart from looking at the credit rating."

Concentration, liquidity

Investors should also be aware of liquidity and concentration. These aspects aren't inherent to debt portfolios, but are critical.

For investors, liquidity means the ability to move in and out of a scheme without impacting the value or price. Open-ended schemes provide that liquidity. But for the fund manager, it's not that simple. The portfolio liquidity has to be constantly monitored so that large redemptions can be addressed without an impact on the net asset value of the portfolio materially. Ravishankar said, "The portfolio liquidity risk is ascertained by classifying in the form of matrix. This shows in what proportion can the portfolio be liquidated in 1, 2, 3, 5, 10 or 30 business days, and so on. It is prudent to fix a limit on illiquid portfolio."

Further, a sudden entry or exit by a large investor may cause the NAV to fall. "This can be avoided by introducing 'swing pricing' as recommended by SEC (US Securities and Exchange Commission) in its proposed rules for better liquidity management. Swing pricing ensures that any NAV fluctuation due to entry or exit of any large investor is factored in the settlement price of that investor, so that the remaining investors' NAV is protected," said Ravishankar.

One way in which some funds manage this is to broadbase their investor profile rather than having only a few large investors whose untimely redemption could cause selling pressure.

Concentration refers to the proportion of exposure to one specific bond. Higher the concentration in only a few bonds, higher is the risk that these bonds pose. For example, in funds that held Amtek Auto bonds, the sharp fall in NAV was also a result of the high exposure to the bond in the portfolio-15%. Had there been more diversification with a lower exposure to that single security, impact on the NAV wouldn't have been so sharp.

Similarly, the duration risk in gilt funds is high because these types of funds invest only in one kind of security, long-term government securities.

Mint Money take

While interest rate risk is more about your medium-term returns and opportunistic buying of debt, credit risk will tell you whether you want to risk losing money altogether. Hence, the latter is more critical for riskaverse investors.

As the choice of fixed income products for retail investors increases, so does your responsibility towards doing the correct checks before investing. Make sure you take a look at the portfolio carefully to determine the concentration and the duration risk. Portfolios can be seen online on asset management websites.

Where you aren't sure about the risk, cross check with a certified adviser rather than trying to analyse it yourself. Remember all fixed income funds aren't the same and have different risks- check before you invest.

In arrangement with HT Syndication | MINT