After Franklin debt mutual funds winding up last week, many debt mutual funds investors are in a shock. Not just those whose money got stuck in one of the six closed Franklin funds. Even other investors are worried about their debt mutual fund investments. They do not want a Franklin like closure happening with any of their funds.
And their fear is not justified. If they had invested in debt mutual funds as a replacement for bank fixed deposits, this is not something they signed up for.
Are your debt mutual fund schemes safe?
What should you do to find that out?
Here is what you must do if you have invested in any debt mutual fund scheme.
Check the Debt MF scheme portfolio regularly
AMCs are required to disclose the scheme-wise portfolios on a monthly basis. As an investor, you will also get the link to the portfolio in an email. You can also go to AMC website to check the portfolio (Search for Portfolio Disclosure)
Check the portfolio. Look at the kind of securities that your scheme. For most of us, it is not easy to figure out the borrowers since borrowing can happen through special purpose vehicles (SPV). However, the portfolio disclosure contains credit ratings too. So, that will give you a fair bit of idea about the quality of the portfolio.
Do note portfolio data is available on ValueResearch and Morningstar websites too. However, ValueResearch does not show the complete portfolio. Morningstar shows the complete portfolio but does not show the credit ratings against each security. So, you must review your scheme portfolio (as released by the AMC) on a regular basis.
These days ValueResearch also shows an interesting graph for each debt fund. You will find the breakup of the portfolio across various credit ratings. By the way, similar data is available in Morning Star fund factsheets too. Let’s see these graphs for a few debt mutual funds.
I start with Franklin Ultra Short Duration Fund and subsequently show rating breakup for a credit risk fund, a low duration fund, and a Banking & PSU Fund. I have deliberately removed the scheme names. The data is as on March 31, 2020.
Note that the X-axis keeps changing i.e. credit ratings on the X-axis are not necessarily in the same order.
What to look for?
Higher the allocation to AAA, A1+, SOV and Cash, the better it is.
In the current times, the lesser exposure your scheme has to AA (includes AA+, AA and AA-) and A & below, the better it is. This threshold could be say, 10% of the portfolio.
Moreover, the bonds from many banks and a few blue chip companies are rated AA and that might increase weightage to AA basket. Personally, I am fine having such bonds in my portfolio (you do not have to agree). At the same time, I do not like investments in perpetual or AT1 Bonds of banks, especially those of weaker banks. We all know what happened to AT1 bond holders of Yes bank. A few debt MF schemes took a heavy hit, one going down by as much as 25%.
Note that higher credit rating is no guarantee that there won’t be any default. We have seen that before. However, it gives you the comfort.
Additionally, you need to need to check if the fund has disproportionate exposure to a single company or promoter group.
Keep an eye on the Assets under Management (AUM) of the Scheme
If your mutual fund scheme is losing assets quickly, it is a red flag. I have written about this in detail in this post.
If your debt fund scheme does not have a very high credit quality portfolio (exposure to AA and below is high) AND is losing assets under management at a brisk pace, you must be very vigilant.
You must understand, if the AUM of the scheme goes down sharply, the proportion of low credit quality assets in the portfolio will likely increase. This means the portfolio keeps getting inferior and inferior.
You can look for the AUM trend over a few months.
Point to Note
AMCs disclose portfolios on a monthly basis. The AUM size that you find on ValueResearch or MorningStar is month-end data only.
Therefore, a lot can happen between say the end of March and the end of April. The scheme portfolio will not be available in the interim period. However, you can still check the size of the scheme on a daily basis on AMFI website.
If the credit quality of your scheme portfolio is suspect, you might want to check the size of the scheme on a more frequent (than monthly) basis.
What if I cannot live with credit risk?
Note, no matter how meticulous you are, there is still a chance that your debt MF portfolio may experience defaults. You can’t avoid credit or default risk completely (unless you invest in gilt funds).
What if you cannot live with any credit risk?
Then you do not live with credit risk. Investing is not about braggadocio.
More so for fixed income investments where your upside is capped. With equity investments, being brave when everybody is afraid can be quite rewarding. No such rewards for fixed income investors (especially debt MF investors).
In fact, if your portfolio risk far exceeds your risk appetite, you will end up compromising not just your wealth, but health too.
You are better off investing in a bank fixed deposit.
Many of us invest in debt mutual funds for tax arbitrage. Interest from fixed deposits is taxed at your income tax slab rate. On the other hand, short term capital gains in debt mutual funds are taxed at slab rate (no difference). The long-term gains are taxed at 20% after indexation. And this is what attracts many investors to debt mutual funds. LTCG tax rate can be much lower than your slab rate.
However, if you look closely, this tax arbitrage does not even exist for investors in the 0%, 5%, 10%, 15% or 20% tax brackets (LTCG tax will be about 10-15% at current levels of CII growth). Therefore, such investors must seriously revisit their choice of investing in debt mutual funds. I have discussed this aspect in detail in this post. You might argue that debt mutual funds can give you better returns than bank fixed deposits on a pre-tax basis too. Yes, they can but all this comes with risk and you must appreciate that. There is no free lunch.
You must also see if the risk of debt mutual funds is worth it.
For those in the highest tax bracket, debt mutual funds can be appealing but you need to select the right mutual fund too.
You must compare the alternatives too.
If you are looking for income, you can look at RBI Savings Bonds, tax-free bonds, Government Bonds apart from bank fixed deposits.
If you are looking for debt investments for long term portfolio, PPF and EPF are excellent options. Yes, PPF remains very attractive despite the rate cut.
Are there any options in Debt MF that are without credit risk?
Yes, there are. You can invest in Gilt funds that invest solely in Government securities. Hence, there is no credit risk.
There are many gilt funds in the market but the duration (or the interest rate risk) for such funds is quite high. Therefore, even though there is no credit risk, the NAV of such funds can be quite volatile. For more on interest rate risk, refer to this post.
There are a few liquid funds that invest solely in treasury bills. You can look at such funds too. There is no risk of default. However, treasury bill yields are down to less than 4% p.a. (April 29, 2020). You will likely get better returns in a bank fixed deposit. Of course, this can change.
It is not about what will happen. It is about what can happen. There are many possibilities. A few of them, the investors may not be comfortable.
What you should not do?
After Franklin debacle, there are many AMCs that are pushing their credit risk funds aggressively. For most investors, it is a category that should be avoided.
More so in current times, the weaker companies can face immense financial pressure. Therefore, do not fall for the sweet talk.
Interest rates have been inching lower for some time. Small savings scheme interest rates were also cut recently. While there is appeal in high return products such as corporate fixed deposits and NCDs, resist the temptation.
Do not unnecessarily chase yields. Can backfire.
If you are an NRI, you have the comfort of NRE fixed deposits. There is little need to invest in debt mutual funds (unless you want to invest NRO money).