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Down due to downgrades

Lately, rating downgrades have resulted in debt funds losing money. Here is what has caused this and what it means for you

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Once bitten, twice shy - that seems to be the frame of mind Indian credit-rating agencies are in these days. It all started last year when IL&FS group companies defaulted on their payments and rating agencies were forced to effect a sharp downgrade from AA+ (high grade investment) to D (investment in default) in a matter of days.

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Besides triggering panic in debt markets, the action put a question mark on the credibility of credit ratings.

It is hardly surprising that credit-rating agencies have come under closer regulatory scrutiny since that episode. They have responded by turning extremely cautious. The bonds held by mutual fund schemes reveal that incidents of rating downgrades have shot through the roof in the recent months. The last two quarters, since the IL&FS crisis broke out, have seen 319 bonds of 63 issuers being downgraded. That's more than the total number of issues downgraded in the preceding three years combined.

The ongoing stress in the NBFC sector has of course contributed to this spike. But even if this crisis sorts itself out, more frequent downgrades may be the norm as the regulatory glare is expected to keep rating agencies on their toes. So, what are the implications of this downgrading spree for debt-fund investors?

A rating downgrade means a bond has become riskier than before and the markets react to this by marking up its yield. This leads to a drop in its market price and in turn the NAVs of mutual fund schemes holding it.

While the rating agencies have been handing out more frequent downgrades, SEBI and the industry body AMFI have simultaneously nudged AMCs to immediately mark down the value of their bonds in response to rating cuts. Given that most corporate bonds held by mutual funds are not frequently traded, such mark-downs used to be discretionary earlier. But AMFI has recently issued standard guidelines to AMCs on the exact extent of write-downs ('haircuts') they need to take when bonds sink below investment grade.

As a result, the NAVs of several debt funds have suffered sudden blips in the recent months. The DHFL episode is one such example. In the first week of June 2019, DHFL delayed its interest payments, leading to rating agencies downgrading its bonds to D grade. Debt funds had to take a haircut of as much as 75 per cent on the value of these bonds based on the new AMFI norms. This led to 90 debt schemes reporting a single-day fall of more than 5 per cent in their NAVs.

These developments have made debt funds more volatile. Arvind Chari, Head - Fixed Income & Alternatives at Quantum Advisors, says, 'Rating agencies have become more vigilant. Besides, they have been advised by the regulator to also factor in the market yields into their ratings. If this continues, the volatility will be higher, especially in funds which have a high credit allocation.' SEBI's emphasis on the market-based valuation of bonds in liquid funds has also added to these incidents.

All this has resulted in a rising proportion of negative returns even on debt categories that were traditionally seen to be less volatile. Data analysis by Value Research shows that in 2018 negative returns from liquid, ultra-short, low-duration and money-market funds stood at 4.9 per cent of the time; they were just 0.9 per cent of the time in 2009.

Should investors worry about it? Well, it is in their long-term interest. More proactive rating changes and quicker mark-downs in bond values help keep debt-fund NAVs closer to reality. Speedier reflection of poor bond selection in NAVs can act as a big deterrent for fund managers taking on riskier bonds. Sunlight after all is the best disinfectant.

It has an unintended consequence though. A sharp fall and subsequent recovery in the NAV (in case the ratings of the underlying bonds are restored) can put its existing investors at a disadvantage if the fund experiences inflows in the meanwhile. That's because the new investors will end up getting a windfall when the NAV recovers at the expense of old investors who actually bore the entire brunt of the mark-down. Taking cognizance of this, many funds that took a hit in the recent DHFL episode have disallowed fresh investments to safeguard the interests of existing investors. Side-pocketing is another option available to them.

Investors need to re-align their expectations from debt funds and be prepared to embrace more ups and downs. Today, even a small decline in the value of a bond fund is seen as nothing less than shocking. But the realisation needs to set in that debt fund managers' calls can on occasion go wrong.

Also, ask yourself whether you are being suitably rewarded by way of liquidity, returns or tax efficiency for giving up the safety of assured returns that bank deposits or small-savings schemes offer. The next and more important thing is to keep it simple and stick to the few categories of debt funds that can adequately serve your needs.

Down due to downgrades

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