Credit Risk Debt Mutual Funds: Basics an investor should keep in mind

Post Franklin saga, an effort to answer some underlying fundamental questions. Why it happens that happens… whether this is for me… if yes, which one?

In a recent unprecedented move, Franklin Templeton (a global major mutual fund house) wound up six of its debt schemes (> Rs 25,000 crore) stopping any further on-demand redemption. The reason attributed – mounting liquidity and redemption pressures amid Covid2019 crisis.

The event created widespread panic among investors who rushed to redeem other schemes across fund houses. The underlying belief was shaken – ‘debt funds being liquid on demand’ – the way they were always marketed !

Since then hundreds of articles have been written on the topic. Most of them can be categorized into two extreme buckets –

  • How Franklin was an exception and the event should not be generalized; or
  • How this is a system wide issue

For me everything can be an exception and everything can be systemic.

What I could not find so far is a basic primer on these kind of funds explaining to an investor why it happens that happens… whether this is for me… and if yes, which one?

The current post is an effort to address the basics underlying this asset class so that an investor can take a more informed decision in the future.

Investing in any asset class is never black or white. What matters is a awareness of what one is getting into.

What are Credit Risk Debt Mutual Funds (CRDMF) ?

All Debt MFs invest into government debt, PSU debt and Corporate debt. In general, Government is considered to be the safest, followed by PSUs and then private corporates. The underlying securities can be bonds, debentures, commercial papers, structured instruments etc etc etc.

Riskiness of a PSU and Corporate is typically indicated by it’s credit rating – AAA being the highest, followed by AA, A, BBB, BB, C & D.

CRDMF, a subset of debt funds is allowed to invest higher proportion of it’s corpus i.e., >65% into debt that is rated AA or lower

The underlying reason for taking higher risk is to try generating higher return and hence make it attractive for the investors.

Isn’t lending supposed to be done by banks and why do Companies even borrow money from the MFs?

This is an obvious question – as for all practical purposes these MFs are lending to the Companies – a function that is normally associated with the banking or finance companies.

So why?

It’s because banks and finance companies work under a defined set of regulations, structure and risk-assessment procedures, whereas MFs can be much more flexible. E.g., banks rarely lend against land/ shares whereas MFs do. Likewise MFs can be much more creative in designing repayment structures vis-a-vis the banks.

You may not be blamed, if you are itching to name Credit MFs as shadow bankers.

What about risk assessment/ protection? Who does it?

The first point of check is always the external credit rating of the subject instrument and the borrower. As defined above, the ratings vary from AAA to D.

However, MFs don’t just look at the rating and decide. There is Chief Executive Officer (CEO) and Chief Investment Officer (CIO) who decide the strategy, credit team who sources and analyzes the deals and then finally the internal risk assessment/ control committees who provide the final go ahead.

No one and let me repeat that no one in the chain as such wants to lend, forget and lose fund’s money.

No fund house wants to lose money by design

Why do investors invest into them?

Diversification, returns and liquidity

Diversification – in terms of allocations of the overall portfolio. Debt is generally considered safer than equity.

Returns – especially when compared with the bank deposits. During certain time periods (e.g., declining interest rates) they can provide significantly high returns.

Liquidity – as ‘normally’ they are redeemable on demand

Why do Franklin kind of events happen?

Here where it gets interesting…

Every mutual fund house today chases size… why?… it provides them with negotiating power, increases their management fee and hence revenues and hence valuations…

How do they chase size?… by offering high commissions and differentiating products (mostly as higher returns) to the advisors who get the funds for them. If everyone is offering the same product, then obviously only few big names would get all the funds and others can take a walk.

Why higher returns and not lower risk as a differentiating strategy?… tell me how many investors would be interested in lower risk vs higher return products? All of us make noise when the things go kaput – before that what we want are as high returns as possible.

Ok, high returns and hence higher risk but how can the scheme be just closed? Isn’t ready liquidity (at whatever value) was a given?… Theoretically yes, it should have the ready liquidity at some value. However, that’s how debt markets function and more so in India. Debt unlike equity has this unique characteristic – the market and hence liquidity just dries up for doubtful credits. Besides, the current market conditions are unprecedented where no one knows what the future entails.

Under stable or growing economy, Credit MFs do reasonably well. Problem comes when there is distress in the economy as Companies start struggling to repay their obligations and hence the liquidity and secondary market dries up for doubtful credits. The problem further gets compounded when the future is as uncertain as it is currently.

Overconfidence of the managers + preference for higher returns by the investors

Will fund houses or regulators bail me out in case of default? Can I make advisors responsible?

Why should the fund house or regulator do the bailout? The details on scheme assets were always available in the public domain. Informed investors would have already taken an exit.

Yes, if you have a reason to believe that the fund house or the advisor has misguided you or hidden some information, you have a legal recourse.

None of them become automatically liable in case of defaults. The bigger problem lies in the investor awareness around these products.

Should I really be investing into them and with what precautions?

In investing there is no right or wrong asset class

It’s what suits you in terms of your own capabilities, skill sets and risk-return expectations.

I have many friends who love this asset class and others who just hate it. Both kinds have their own perspective and both are doing good.

Precautions that I would take while looking at debt funds –

Asset quality mix – with debt I am more interested in playing a relatively safer bet where underlying borrowing companies are known names with no concerning news around them. Obviously, I would need to monitor this regularly and with first hint of red flag, I am out !

Pedigree of the fund house – most-2 important. I personally like bank promoted debt mutual funds. Reason – think about it, these MFs are taking credit exposures and banks have a better pedigree in that field. Bank promoted MF will always have an upper hand both at the time of entry and exit into any deal. Besides, the underlying scare of the impact of any wrong doing on the larger brand name always plays to the advantage of the investors.

I hope to have answered all the basic questions and hope this was useful. Please feel free to comment if I have missed out on something and I will surely respond.

Times are unprecedented and no one really knows what lies ahead. As they say – ‘it’s better to be safe than sorry’

Wish you safety and I am sure that post Covid2019, we all will emerge stronger than before !

Disclosure: Above is my personal opinion and not any recommendation to the reader. He should do his own research before taking any investment related decision.

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1 year ago

The post helped clear some doubts…thanks

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