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Avoid concentration to avoid credit risks

Here are a few important things debt fund investors need to know about portfolio concentration

Avoid concentration to avoid credit risks

If you're a relative newbie to investing, you may feel that the due diligence expected of you on ratings, instruments, etc., is quite a tall order. But if you don't have the ability to sift through different instruments or deep dive into ratings, there's one easy check to keep your credit risks down. Do your due diligence on portfolio concentration.

Just run through the debt fund's portfolio weights in different instruments to see if any individual exposure exceeds 5 per cent. You needn't worry too much about government bonds but corporate-bond exposures that exceed this limit are a red flag, especially if they are below top-quality AAA or A1 bonds.

In 2016, the SEBI tightened its diversification norms for debt funds to cap the single-issuer exposure at 10 per cent, with funds allowed to stretch this to 12 per cent with the approval of their trustees. Exposures to a single corporate group are set at 20 per cent, while those to a sector are at 25 per cent of assets.

However, recent credit events suggest that the regulatory limits are still quite liberal and can leave the door open for sharp shocks to investors from write-downs. Given that the typical corporate bond yields 7-8 per cent annually, if a bond that has a 10 per cent weight in the portfolio faces a default, it can wipe more than an entire year's returns for investors.

But a lower 5 per cent single-issuer cap can ensure that even if one issuer has to be entirely written off, the fund can still deliver a positive return. This is why seasoned debt managers privately admit that they have set internal limits for their corporate bonds that are far lower than the 10 per cent limit specified by the SEBI. Some have a 5 per cent cap on any instrument rated below AA.

Others set further sub-limits at 3 per cent and 2 per cent for bonds with lower rating profiles and specific issuers, based on internal assessment.

Rahul Buskute of ICICI Pru AMC says, "We have product-wise, category-wise and even an AMC-level cap on concentration risks. We track our exposure as an AMC to different corporate groups at the aggregate level. We do this at the promoter level, too, as risks can transmit from one group entity to another." The fund discloses these additional details in its factsheets for investors to make their assessments.

It is not just on account of the danger of downgrade or default that some AMCs swear by these stringent single-issuer limits. They also do it to manage liquidity risks in their portfolios. Given that the bond market in India has relatively few participants across tenors, many categories of bonds cannot be readily encashed. Apart from lower-rated corporate bonds, even very long-term sovereign bonds suffer from illiquidity. These can become tricky to handle in open-end debt funds in the event of sudden redemption pressures.

As Dhawal Dalal comments, "Liquidity is like a mirage in the corporate-bond market. The fund manager thinks it is there, but when he or she needs it, it may not be there at his or her levels. So the best way to ensure some liquidity in the portfolio is through holding liquid G-secs, AAA bonds or top PSU names at all times. A prudent fund manager will always have a pocket of liquidity in his funds. Apart from this, fund managers ought to answer the following question before buying any bond: who is the next buyer and at what level?"

Avoid concentration like plague