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Don't go by the label

If you think some debt funds are completely safe from credit risks, you should read this article

Don't go by the label

Did you think that liquid and ultra-short-term debt funds are completely safe from credit risks, while income funds and credit-opportunities funds are prone to them? If you did, it's time to change your mind.

Whether a debt fund in your portfolio suffers from sudden NAV blips due to credit events depends on two things - the mix of government and corporate bonds in its portfolio and the rating profile of those corporate bonds. Just because a fund labels itself as 'liquid' or 'ultra short term', this is no guarantee that it carries zero credit risks. Whether in the BILT case or Amtek Auto case, short-term funds, liquid funds and ultra-short-term funds of the said AMCs took a hit from a credit downgrade because they weren't completely free of credit risks.

In fact, an analysis of the portfolios of different debt-fund categories tracked by Value Research shows that of all the debt-fund categories, only gilt funds (both long term and short term) actually stay completely away from corporate-bond exposures. Most other categories of debt funds are quite heavily reliant on corporate paper for their bread and butter.

Seasoned debt managers say that there is increasing pressure on conservative debt-fund categories to take on either credit or duration risks because flows in the industry mostly accrue to those funds that top the charts on returns. As Dhawal Dalal, Head of Fixed Income at Edelweiss AMC, frankly puts it, "Since inflows generally follow near-term performance of the scheme, there is either some amount of credit risk or duration risk in the portfolio that needs active management. It has also been observed that investors have been rewarding performance more than prudent fund management. As a result, credit quality has generally been nudged for performance." He believes it is important for investors to not just look at returns but to assess where the alpha came from.

Value Research analysis shows that as of February 2017, liquid funds on an average had parked over 80 per cent of their assets in corporate paper, with 20 per cent in cash equivalents or sovereign paper. Within corporate paper, A1+ commercial paper dominated, with an average 62 per cent allocation. Medium/long term corporate bonds rated AAA made up another 3.4 per cent of the portfolios. But the category also had a 3 per cent allocation each to AA-rated and A-rated bonds. These are still investment grade, but susceptible to some risk.

There is also considerable divergence in the extent to which different liquid funds take on credit risk. Within the broad category of liquid funds, you have Quantum Liquid Fund, which played it extremely safe, with a 90 per cent exposure to treasuries or money markets and a less than 10 per cent weight in corporate paper (as of February end 2017). But you also had Franklin India Cash Management Account Fund, which had less than 20 per cent weight in sovereign and money-market instruments and allocated the rest to corporate paper - 64 per cent in A1+, 14 per cent in AA corporate bonds and 4 per cent in A-rated bonds. Investors may need to make a call between the former and the latter based on whether low risk or a higher return is their priority.

As a category, the average ultra-short-term debt fund relied on an 85:15 ratio between corporate bonds and sovereign/money-market instruments. The corporate portion in this case had an allocation of over 40 per cent to medium/long-term corporate bonds. AA-rated bonds made up about 20 per cent of the portfolio on an average, with the top-quality AAA paper at about 30 per cent.

Again, there was considerable divergence in portfolio quality between funds. If DSP BlackRock Ultra Short Term Fund played it very safe with over 95 per cent of its money parked in A1+, AAA or sovereign paper, you also had ICICI Pru Savings or SBI Savings, which had 40-odd per cent of their portfolios in AA-rated corporate bonds.

This is not to say that investors should be alarmed at the very presence of AA-rated bonds in their debt funds. After all, if your intent is to earn higher returns you must expect incremental credit or duration risks. AA corporate bonds are only a notch below top-quality and carry a near-zero probability of default. But such bonds can carry liquidity risks if market conditions are unfavourable.

Don't go by the label