Protecting your debt fund portfolio in the times of Corona Virus

Protecting your debt fund portfolio in the times of Corona Virus

With the entire country and large parts from all over the world stuck in lockdown and fearing what is to come next, the full extent of the economic aftereffects of the lockdown remains unknown to date. Investors need to be particularly cautious at this time and need to take several steps to ensure that their debt fund portfolio remains safe, and as far as possible, unaffected in the times of Corona Virus.

Here are three risks that are most likely to affect these investors: credit risks, duration risks and liquidity risks; and what can be done to prevent them.

1.    Credit risks

The bitter truth is that small business do not have as much staying power or liquidity as larger businesses and corporates do. And it these businesses that will be affected by the pandemic the most. Most banks and PSU debt funds have their portfolios with corporate and banks, and these sectors might be somehow able to bear the brunt. Credit risk funds, however, have a reasonable risk-reward ratio; and they stand at the threshold of complete uncertainty. This is mainly because their investee companies often stand at the lower end of this broad credit spectrum; and consequently, they are facing a lot of turmoil and ambiguity.

In such a scenario, all fresh investments in credit risk funds can be paused, and investors need to be extra cautious.

Apart from credit risk funds, many funds have invested heavily in AT1 bonds. This has created additional panic in the past few weeks, especially since Yes Bank decided to write them off. Investors now will have to be on the lookout of all debt fund portfolios, to gain insights into the AT1 bonds of the private sector banks. Though weak PSU banks have till now managed to meet all AT1 bond obligations, it has been made possible only with help from the government. And given the present scenario, no one can predict that for how long this government support can continue. From the Yes Bank AT1 bond disaster, what can be safely concluded is that there is no way one can ascertain the risks involved in these bonds by rating institutional investors, let alone retail investors.

On the other hand, a few banking and PSU debt funds, as well as corporate bond funds, are at a much convenient position to medium-term surplus deployment. Thus, in the present worldwide scenario, sticking to mutual funds from large banks might be a safe option.

Investors also need to take note of the fact that the safety offered by the deposits in SBI does not apply to the mutual funds that it promotes since it is ultimately the investor who bears one hundred percent of the credit risk. However, one also needs to keep in mind that the SBI mutual funds have managed to acquit themselves decently well when all others failed. Investors might need to consider skipping fund houses, which have only let them down time and again on the credit risk front, for want of better options that might be available.

Fallen angels:

The debt instruments that have fallen below the investment grade of BBB minus are characterized as fallen angles by the credit market. However, for fallen angels, rising back in the debt world is possible. In the likes of the ‘AAA’ rated ILFS, Yes Bank AT1 bonds and others, however, chances of recovery are quite remote.

During the lockdown period, the Reserve Bank has tried to ease the pain of borrowers to some extent. This comes through moratorium and deferments. SEBI has also provided some relief to credit rating agencies during these tough times. Financial markets, on the other hand, are not as forgiving as the others when it comes to fallen angels that are unable to meet their obligations, and NAV erosions in the debt funds that hold their securities might be a possible scenario.

Duration risk:

When demonetization was announced by the BJP government a few years ago, the 10-year benchmark bond yields collapsed completely. What followed was a windfall for all long term investments, since the liquidity of the banking system went up as depositors from across the nation fled to the banks to deposit their demonetized currency into their bank accounts. Such a dramatic fall in yields has not been seen till now, perhaps due to the lack of open market operation by the RBI, the FPI selling and the overflow of government bonds to finance the stimulus package.

Even though the situations and scenarios of today’s situation do not forecast such a risk yet again, sticking to debt funds that will last for a duration of about two to three years may be considered to be a wise move.

Liquidity risk

One cannot deny that the RBI has taken a significant number of measures to ease the liquidity to lower the burden of the pandemic. However, liquidity for mutual funds continues to be tight, because of factors that come into play here, such as investor redemption. Even during the 2008-2009 financial crisis, debt funds have witnessed a net outflow of more than INR 50,000 crores; which is a huge amount. Back then, it had forced the RBI to take measures to infuse liquidity into mutual funds through banks. Since then, the debt mutual fund industry has grown to an INR 14 lakh crore giant, with great importance to the economy. Despite its abysmal track records of lending and poor governance standards, the SBI rescued Yes Bank. This only gives hope to the fact that a much more cleaner industry like debt mutual funds, will get the required support from the RBI as and when the need arises. In the meantime, cautious investors should stick to mutual funds that are backed only by big banks which also have good track records. At the same time, one has to be mindful of the market risks that are involved in the mutual fund schemes out there.