The JP Morgan episode flags that 'accrual' funds can be just as risky as long-term gilt and bond funds
15-Oct-2015 •Aarati Krishnan
To most investors, the prospect of earning a higher return by taking on higher risk is appealing - until the 'risk' part actually begins to make itself felt. Events this month at JP Morgan Asset Management underlined this.
Two debt funds from this fund house - JP Morgan Short Term Income Fund and JP Morgan India Treasury Fund - took a sharp knock to their NAVs after a drastic rating downgrade on Amtek Auto debentures by rating agencies. This subjected the schemes' investors to sudden losses. Adding insult to the injury, the fund also decided to curtail redemptions on the two schemes to one per cent of outstanding units.
While JP Morgan AMC has not offered much by way of explanation for this debacle, the postmortem analysis of how it played out flags four areas that we may need to pay special attention to in the case of debt funds.
What's the rating profile?
Debt-fund investors have so far believed that 'accrual' funds, which invest in higher yielding corporate bonds, are a steadier category than 'duration' funds, which take long-term rate calls for higher returns. Past events have led them to believe this.
While long-term gilt and income (duration) funds have suffered through quite a few stormy phases during interest-rate swings in the last three years (the July 2013 episode is still fresh in our minds), accrual funds have been less volatile because they faced hardly any instances of default by issuer companies. In the isolated instances where they did face them (Lotus AMC in 2008), the scheme was silently and quickly bailed out either by a takeover or by the sponsoring institution buying up these bonds.
But given that mutual funds, unlike banks, have no official guarantee mechanism in place to back up their bad assets, one cannot expect bailouts every time a debt fund faces the prospect of a corporate default. Therefore, it is largely up to investors to ensure that while buying high-yielding debt funds they aren't taking on more risk than they can handle.
Running through the latest portfolio of a scheme to check for the rating profile of its holdings (break-up between AAA, AA and the rest) is one obvious check. But given the tendency of rating agencies to act after the fact, investors who are really risk-averse may have to steer clear of funds which feature any AA or lower-rated papers to completely avoid risk. In fact Amtek Auto was rated AA- by CARE and A+ by Brickworks before it suffered losses, ran into financial problems and was downgraded by both the agencies. One can assume that AAA bonds cannot be suddenly downgraded to default grade.
Fund houses which do not rely blindly on external rating agencies and have an in-house credit analysis team to make their own assessment of corporate bonds may be preferable. But while advisors may be able to make such checks, it would be quite difficult for a retail investor to do so.
A second vulnerability in debt funds which the JP Morgan incident has uncovered is concentration risk. After taking sizeable hits in 1999-2000 through concentrated tech stock exposures, equity-fund managers are now careful about not allowing their individual holdings to top 5-6 per cent. The Sebi too imposes a regulatory limit of 10 per cent on the individual stock exposures of diversified equity funds.
But the Sebi's individual security limit is 15 per cent for debt funds and many schemes flirt dangerously close to this limit. In JP Morgan's case, the hit to the NAV from the Amtek Auto downgrade is severe, mainly because one scheme held exposures as high as 15.2 per cent to this one company.
While concentrated exposures to G-secs aren't that much of a risk, given that G-secs usually have ready buyers, exposures of 5 per cent plus to individual corporate bonds can hurt if the exposure goes awry.
Corporate defaults can subject a debt fund to a double whammy. Apart from losing capital due to write-offs, the scheme can also suffer due to liquidity risk. Once a bond is sharply downgraded, it may be quite hard to find takers for it, even at its so-called market value. The fund may thus get stuck with the paper and be forced to sell its more liquid holdings if there is a rush to redeem units.
Perversely, this would subject remaining investors to even higher risk!
Are assets shrinking?
Value Research has always held that investors should not give undue weight to fund size while selecting their mutual funds as it makes little difference to a fund's performance. Fund performance, after all, depends on the security-selection skills of the fund manager, which can be good or bad even in behemoth schemes.
However, the JP Morgan episode imposes a caveat to that rule in the case of debt funds, especially those with non G-sec exposures. If a debt fund investing in corporate bonds sees a steady outflow of money, both its security selection and its portfolio concentration can go speedily out of whack.
When a bond fund which owns illiquid or lower-rated bonds faces redemption demands, it may actually have little choice about the bonds that it would like to retain and those it would like to quickly exit. A reasonable fund manager would respond to the redemption pressure by selling off his riskier or less desirable holdings. But given the imperfections in the Indian bond market, he may be practically unable to do so. This may force the manager of an open-end corporate bond fund to actually exit the more desirable exposures in his portfolio in times of distress.
Now, it would be quite difficult for any investor to gauge which securities in a debt fund's portfolio are liquid and which aren't. However, there are two ways to reduce risk on this count. Exit or avoid schemes which have seen a sudden or relentless shrinkage in assets. And run regular checks on monthly factsheets to ensure adequate diversification. A more fragmented corporate bond portfolio, due to lower individual exposures, will be easier to liquidate in the event of pull-outs.
Finally, investors who have invested in income or corporate bond funds with a full understanding of their risks should avoid the temptation to flee their funds in panic after this episode.
After the Amtek Auto saga, gilt and income funds, which avoid all credit risk and take only duration calls, may suddenly seem a lot 'safer' to investors seeking higher returns.
But this is a knee-jerk response. In July-August 2013, when the RBI suddenly hiked interest rates to rescue the rupee, all duration funds took a tumble, and many investors exited these funds. In retrospect, staying put or investing in duration funds at that juncture would have helped investors reap double-digit returns.
Today, it is hard to say if income funds or corporate bond funds will see more Amtek Auto-like episodes in the coming months. But if so, their portfolios always carried that risk. The JP Morgan episode doesn't suddenly make them riskier.
Overall, what the JP Morgan debacle essentially proves is that if you're seeking a high return, you cannot hope to sidestep the risk that comes with it. Risk, whether from wrong credit calls or wrong rate calls, is best handled by diversifying your own portfolio fund houses and schemes and not placing too many eggs in one basket, however strong that basket may appear to be.