Debt mutual funds are again in the news.
On June 4, 2019, DHFL could not make the interest payment on one of its bonds. It says that it will pay in another week. Does not matter. Even the slightest delay is considered a default. As per extant rules, even if a default happens in one security by DHFL (not the one held by the fund scheme), the value of the all the bonds from DHFL held by the fund scheme must be written down. And that’s what happened. On June 5th, CRISIL and ICRA also downgraded DHFL to D (Default). Many debt mutual fund schemes suffered badly.
Here is the single day fall in NAV of a few debt mutual fund schemes.
Fall in NAV of some of the schemes is simply mind-boggling.
By the way, it is prudent to write-off the entire exposure and stop accepting further investments into the scheme. Why? I have discussed in detail in this post. Side-pocketing is a better option but none of the funds (except one) exercised it. In an earlier post, I had highlighted different risks associated with debt mutual fund investments. This DHFL mess is credit risk materializing.
The reason why this credit event has impacted so many funds is that DHFL used to be a AAA rated (best rated) company a few months back. For this reason, many funds have been caught off-guard. DHFL found a place in not just credit funds but also in some of the seemingly safer ultra-short duration and low duration funds.
You might ask how these fund schemes could hold such concentrated exposures in a single company. Well, it was not always like this. These schemes must have had exposures within limits. However, ever since the issue of IL&FS and DHFL cropped up last year, these funds have seen an exodus of money.
Let’s say there is a fund A of Rs 5,000 crores that hold Rs 200 crores of DHFL debt. So, DHFL exposure is 4%. However, investors (smarter ones) start taking money out once there was a hint of trouble. Let’s say investors take out Rs 4,000 crores from the fund scheme. To meet the redemptions, the fund schemes must sell its holdings, but it cannot sell DHFL. Why? Because nobody wants to purchase it or purchase it at the price at which the fund manager wants to sell it. (This is also a commentary on lack of depth of bond markets in India). The fund size is down to Rs 1,000 crores. The fund still holds Rs 200 crores of debt. A 4% exposure has now become 20% exposure. If there is default now, the NAV can go down up to 20%.
Tata Corporate Bond lost 29.7% on a single day. As on June 4, 2019, the fund size is Rs 184 crores (it was Rs 536 crores in August 2018). I can safely say almost all this money is from retail investors. If such investors were working with an advisor, they must fire their advisor. Do note, the default did not happen out of the blue. There were concerns about DHFL for a few months now. If your advisor didn’t realize this, you have a problem. Remember institutional investors/corporate treasuries are major investors in debt mutual funds. They will take out their money at the slightest hint of risk.
Some of the aforesaid plans are Fixed maturity plans (FMPs). FMPs are closed-ended debt funds. FMP investors are even worse off. Even if they realize that one of the portfolio holdings has a problem, they can’t exit their position. Recently, HDFC and Kotak AMC held back payment on their FMPs on maturity since they were yet to receive payment from the Essel group. More on this in this article in Mint.
You can’t eliminate risks from Debt Mutual Funds
There is no way you can eliminate risk from your debt mutual fund investments. You need to select the right kind of funds for your portfolio. As per SEBI classification, there are 16 types of debt mutual fund schemes.
As you can see, even Government security funds (Gilt Funds) can hold up to 20% non-Government securities. Government securities have no credit risk. Since there is no category for short term gilt funds, your gilt funds can carry substantial interest rate risk.
What happens next?
It is possible that DHFL may make the interest payment on bonds it defaulted soon. The fund schemes that held those specific bonds will write back the interest payment to their NAVs. No such luck for the principal payments or for the schemes that hold other bonds from DHFL.
Some of the debt funds have their exposure maturing in the near future. If they are lucky to get their money back, they will write back to entire amount (both interest and principal payment) to their NAV and such investors wouldn’t have lost anything (if they didn’t redeem and the mutual fund stopped fresh purchases).However, there is a big “What if”.
What if DHFL does not pay?
Whatever has happened is history. You can’t change it. Let’s look forward and understand what you can do to avoid this mess in the future.
- Make a choice between debt mutual funds and bank fixed deposits. A debt mutual fund will never be as safe as bank fixed deposits. If capital security is your primary concern, then bank fixed deposits are a clear winner. At the same time, debt mutual funds enjoy a much favourable tax treatment as compared to debt mutual funds, which may tilt the choice in favor of debt mutual funds. Your tax bracket and investment horizon also play a role. Investors in the 5% tax bracket have limited incentive to go for debt mutual funds. I have discussed these aspects in detail in the following posts. Post 1 Post 2
- Choose the right type of debt mutual funds. For most of my clients, I prefer funds with low-interest rate risk (overnight, liquid, ultra-short, low duration, money markets funds, etc), low credit risk and low expense ratios. I prefer big schemes (large AUM) from bigger fund houses. I have discussed the checklist in detail in this post. If you are picking up a fund with higher credit risk, appreciate the risks involved. Do not chase the past returns. More often than not, this approach will land in trouble in case of debt funds.
- It is important to keep an eye on the size of your fund and the concentration of exposure to a company/promoter group. It is a red flag if the size of your fund has been dropping consistently. You can find this out on ValueResearch website. Alternatively, the AMCs disclose scheme portfolios once every month. Keep an eye.
- Exit funds that are losing corpus and are developing concentrated exposure. Tax liability on exit may prevent you from exiting immediately, especially for those in the 30% tax bracket. Consider the pros and cons before making a choice.
Remember IL&FS and DHFL used to be AAA rated companies (Can’t trust credit rating agencies). If such companies start going bust overnight, it is only a matter of time when you get caught (as a debt fund investor). The lack of depth in bond markets may prevent fund managers from adjusting their positions despite knowing about the prevailing issues. By the way, fund managers can’t be completely absolved either. Understand the risks associated with debt funds before considering them as replacement for bank fixed deposits.
And yes, spare a thought for those who invested in NCDs from DHFL.
My clients and I had a minor impact due to DHFL default. We had exited the big positions in the funds (where DHFL exposure was high) much earlier. We did not exit some positions because of the tax considerations or because the fund allocation was very small. Therefore, the overall impact was very limited.