Setting boundaries

Value Research spoke to a few seasoned debt managers on the issue of India's debt fund problems. Here Amandeep Chopra, Head of Fixed Income, UTI AMC takes a few questions about credit risks in debt funds.

Recently, we have seen some debt fund NAVs being hit by sharp downgrades in some bonds they held. The quantum of NAV declines were clearly triggered by concentrated exposures to the lower rated bonds. So what are the safeguards that UTI AMC has in place in its debt funds, to avoid this?
SEBI sets broad limits on debt fund exposures to sectors - like NBFCs, and to issuers. The broad issuer exposure limit is 10 per cent, which funds can stretch upto 12 per cent with the permission of their trustees. But from a risk mitigation perspective,individual fund houses like ours often choose to have tighter safeguards.

In our Income Opportunities Fund, for instance, we have two-level limits. For paper which is AA or below the exposure limit is 5 per cent. For singleA paper the limit is 3 per cent or less. We essentially set these limits after looking at what proportion of our portfolio yield can be impacted by a credit event. In a fund like this, it is desirable to have considerable diversification too. For instance if we own single A paper, I would prefer to spread it out with exposures of 0.5 per cent each, so that any industry event or six sigma event does not impact the portfolio.

We also have our own internal filters, apart from the external credit rating, to filter lower rated bonds. Today, credit funds in the industry manage about a trillion rupees. Single A and unrated exposure is about 30-35% of that. About 40% in in AA and the remaining is still in AAA, A1 plus etc. This is reflection of the fact that while there are a number of issuers with ratings of single A and below, the acceptable investment universe is not that large.

So, how do you define your debt fund mandates to restrict credit risk?
We have clearly segmented the market. Within each maturity bucket, we have both a high investment grade product and a high yield product.

So in the short term category, we have a UTI Banking and PSU Debt Fund and UTI Short Term Income Fund, where we don't invest in any bond rated below AA plus. These funds mainly own sovereign or quasi sovereign instruments. In the same category, we also have a UTI Income Opportunities Fund where below AA exposures are capped at 50 per cent of the portfolio. Within that, we have 5 per cent and 3 per cent limits for individual bonds.

In the Medium to long-term category, we have a high investment grade UTI Bond Fund, UTI Dynamic Bond Fund and UTI Medium Term Fund - the latter does invest in A and A-minus bonds similarly to our UTI Income Opportunities Fund, but with a longer maturity. Apart from this, we also ensure that our short term funds do not extend their maturity beyond a limit and take duration risks in the process. I think very few AMCs have such explicit limits on their credit and duration exposures. In a bull market, a credit fund should not be outperforming a duration fund of similar category. If so, it indicates additional duration risk.

Are there any funds under the UTI fold that would be suited to retail investors just looking for low-risk debt returns?
I would think the UTI Banking and PSU Debt Fund is quite well suited to such investors who do not want any credit risk. One, we are only invested in sovereign and quasi sovereign bonds. Two, you can also get an excess spread over what you can earn on your own from a bank FD. To illustrate, today a bank FD would yield 6.75 per cent, but a AAA REC bond today yields about 7.5-7.75 per cent. There's the added benefit of indexation too, if you hold for 3 years. I think this category would really be popular with conservative retail investors in a low yield environment.

But we do sometimes come across investors who seek an 8.5 to 9 per cent return. Those returns are quite difficult from this fund in the current environment and they would need to look at UTI Income Opportunities Fund.

So how should investors choose their debt funds? Though they are urged to do more due diligence, it is quite difficult for investors to really track underlying fund portfolios and react to sudden rating downgrades.
Investors need to be very clear about the investment objective and mandate of the fund they are buying into, and whether it suits their risk profile. When a fund does not have a clearly defined objective in terms of the minimum rating it can go into, it is hard to know if it is going down the credit curve to bump up its yield. It is like playing football without any boundaries drawn on the field.

I think it is also important for investors to look at how the fund has handled multiple rate cycles in the last. Since 2008, we have actually had three different interest rate cycles in India. So we do have data on how fund managers and debt funds have handled all these three cycles. A fund which had navigated past cycles well should offer greater comfort.