Is Risk Linked with Credit Risk Funds Justified?

Introduction

Post IL&FS Collapse in September 2018, the corpus of credit risk funds shrunk almost by a quarter. Credit risk funds has been hit by a series of defaults and downgrades over the last one year. Lets do a short analysis of Credit Risk Funds performance. The sharp fall in their Net Asset Value (NAVs) have led to large outflows from this category. In such case, is the risk linked with credit risk funds justified?

Credit Risk Funds Analysis – Is Risk Linked with Them Justified?

• The primary aim of credit risk funds is to offer higher returns to the investors than any other categories of debt fund. Their basic goal is to invest predominantly in low-rated bonds in pursuit of higher returns.
• However, if we compare the returns of riskier credit risk funds with that of safer short duration funds, the result will disappoint their investors.
• In such case, many credit risk fund investor ask one question – Are these credit risk funds worth the risk associated with it?
• Many people will argue that comparing credit risk funds with short duration funds is not appropriate in the current scenario. It is because the credit risk funds are recently witnessing their worst phase due to the ongoing stress in debt markets and the resulting credit downgrades.
• In order to verify the above argument, we have compared both the categories over the last five years to evaluate their performance.

What Are Credit Risk Funds?

• Credit risk funds are debt fund which are mandated to invest a large chunk of their assets (at least 65% of corpus) in instruments rated AA or lower. They do this while maintaining the optimum balance of yield, safety and liquidity.
• Investment in lower rated bonds involves higher risk as it signifies lower capability of borrower to repay obligations and the increased possibility of defaults.
• Thus, while maintaining reasonable liquidity, credit risk funds target high accrual by taking on a marginally higher credit risk.

Investment Strategy

• Credit risk funds look out for opportunities to maximize portfolio yield. They primarily invest in AA and below rated corporate bonds.
• The funds invest predominantly in corporate bonds, which offer good opportunity to leverage credit risk. By choosing a diversified portfolio positioned for growth and stability, credit risks funds seek to provide :
  1. Regular income
  2. Capital appreciation
• To efficiently manage the risks, these funds avoid concentrated portfolios and also cap corporate group level exposure.
• Apart from their core strategy, these funds offer higher yield, with potential for capital gains in the event of a future upgrade in credit rating of the bonds. Thus adding extra alpha.
• This is because relatively low rated bonds usually offer higher coupon rate and if their ratings are upgraded, the prices of such bonds jump.

Credit Risk Funds Analysis – Comparing with Other Debt Categories

1. Credit Risk Funds vs Short Duration Funds – Comparing Returns

• Short Duration funds
  • These are debt funds that lend to companies for a period of 1 to 3 years. These funds mostly take exposure only in quality companies with rating AAA and above.
  • Those highly rated companies have proven record of repaying their loans on time as well as have sufficient cash flows from their business operations to justify the borrowing. Thus, Short Duration funds are safer than credit risk funds.
• In spite of taking higher risk, the returns of credit risk funds can not beat that of short duration funds. Over last 1-year, credit risk funds have offered merely 1.30% returns vs 6.04% that of short duration funds.
• This is mainly because of back to back downgrades of debt instruments from IL&FS and Dewan Housing Finance (DHFL) by rating agencies.

2. Credit Risk Funds vs Conservative Hybrid Funds – Comparing Credit Quality

• A good credit risk fund should have the ability to deliver 3-4% more returns than a fixed deposit or a conservative hybrid fund.
• In case of conservative hybrid funds, asset allocation is :
  1. 25% in equity : To add growth to the portfolio and
  2. 75% in debt : To generate a consistent income
• These funds look to provide more returns than bank fixed deposits without taking too much risk.
• The debt part of conservative hybrid funds is mostly in high rated securities. But that is not the case with credit risk funds.
• We can see from the above graph, the asset quality in case of credit risk funds is mainly credit rating from AA and below it. While for conservative hybrid funds, it is AAA and above.
• The returns offered by conservative hybrid funds were 8.06%, 5.84%, 7.36% and 8.37% for 1 year, 3 years, 5 years and 10 years respectively.
• These numbers are far better than that of credit risk funds for the respective time horizon.

Conclusion

• Thus, credit risk funds have not justified in terms of returns with the risk associated with them, when compared with short duration funds and conservative hybrid funds returns.
• The subdued returns of credit risk funds post IL&FS crisis, may be because of ongoing stress in debt markets due to credit defaults and the resulting credit downgrades.

SEBI Circular – Changes in Debt Funds applicable in FY 2019-20

Introduction

SEBI (Securities and Exchange Board of India) has improved some fund management regulation for liquid, overnight debt funds. As per SEBI circular issued on 20th September 2019, the recent changes in Debt funds categories are discussed in this article.

SEBI Circular – Recent Regulatory Changes in Debt Funds Categories

• Keeping in mind the recent credit events in fixed income market that led to increase in liquidity risk of Mutual Funds, it was needful to review the regulatory framework and take necessary steps :
  1. To safeguard the interest of investors
  2. To maintain the orderliness and robustness in mutual funds
• Given the background, The Securities and Exchange Board of India (SEBI) has come up with a Review of Risk Management Framework of Liquid Funds, Investment Norms and Valuation of Money Market and Debt Securities by Mutual Fund.

Regulatory Changes in Liquid, Overnight Debt Funds During FY2019-20 as per SEBI Circular

Highlights of SEBI Circular – Here are the changes proposed by SEBI:

1. Liquid funds shall hold at least 20% of its corpus in liquid assets w.e.f. April 1, 2020

• Liquid Schemes shall hold at least 20% of its corpus in Highly liquid assets such as Cash, Government Securities, T-bills and Repo on Government Securities.
• If in case the exposure in these liquid assets falls below 20%, the AMC shall insure compliance before making any further investments.

2. Graded exit load shall be levied on investors of liquid schemes

• A graded exit load shall be levied on investors of liquid schemes who exit the scheme within a period of 7 days of their investment. Graded exit load roughly means the load will be reduced with each passing day up to 7 days.
• Therefore, investors redeeming on second day will have to pay more exit load than investors redeeming on seventh day. The move is a positive for retail investors as it lowers the chances of volatility caused by big flows in liquid fund returns.
• Institutional investors on the other hand have Overnight funds as an immediate substitute to Liquid Funds.

• The percentages though look small in absolute terms but are much significant when compared with the returns of liquid funds in very short period of time.
  • Example : An investment of Rs. 1 crore in liquid fund would fetch around 7%p.a. pretax returns i.e. Rs. 7 lakh. Which is about Rs. 1918 per day. An exit load of Rs.700 (Rs. 1 Cr x 0.007%) would eat almost 36% of the returns(pretax).

3. Liquid Funds shall not park funds in short term deposits of banks

• According to this regulation, Liquid Funds and Overnight Funds shall not park funds pending deployment in short term deposits of scheduled commercial banks.
• In simple words they shall not invest in bank FD’s.

4. Liquid Funds shall not invest in debt securities having SO and/or CE ratings

• Liquid and overnight schemes shall not be permitted to invest in debt securities having Structured Obligations (SO ratings) and/or Credit Enhancements (CE ratings). However they can invest in debt securities with government guarantee.
• What is Credit Enhancement?
  • Suppose a company wants to raise capital by issuing a bond. Now, it may use some external Credit enhancement to lower the interest rate it has to pay to investors.
  • For this it can get a Bank guarantee assuring investors of the repayment or it can even offer additional collateral. This assurance improves rating of company’s bonds which enables it to raise capital at lower interest rates than what it could get otherwise.
• What is Structured Obligation?
  • A structured obligation is a hybrid debt obligation that shall have a derivative component attached to the underlying bond.
  • This will improve its rating by adjusting the risk return profile of the bond. The returns of a structured obligation shall be based on combined performance of underlying bond and the derivative embedded to it.

5. Cut-off timings for applicability of Net Asset value (NAV)

The cut-off timings for applicability of Net Asset value (NAV) in respect of purchase of units in Liquid and Overnight funds shall be 1.30 pm instead of 2.00 pm earlier.

6. Improving transparency in fees levied by fund houses

From 19th October 2019 the Asset Management Companies (AMCs) shall not be permitted to charge Investment management and Advisory fees for parking of funds in short term deposits of scheduled commercial banks (Bank FD’s). This is a move towards improving transparency in fees levied by fund houses.

7. Introduction of Mark-to-Market Valuation Norms

• SEBI has also introduced Mark-to-Market valuation norms for liquid funds. Accordingly, liquid funds will now have to value all securities in their portfolio with a maturity of 30 days or more on a mark to market basis. It was seen that some mutual fund houses were masking the credit risk profile of liquid funds by taking advantage of accrual system of valuation. With SEBI’s new directive fund managers are anticipated to invest in high-quality papers which eventually will lower residual maturity and the instances of outperformance might reduce.
• What is Mark-to-Market valuation?
  • Mark-to-market valuations reflect a security’s Current Market Value. As against the accrual system which accounts for gains that will be realized in the future and isn’t concerned with a security’s current market value. Following accrual system of valuation was one of the main reasons why many liquid funds incurred sudden losses in recent past.
  • Example : A Liquid fund named “X” invested almost 15% of its assets in a zero coupon bond with Rs 1,000 face value for Rs 975 which had a residual maturity of 55 days. Within a week another liquid fund, “Y”, sold the same bond in huge quantity at a discount price of Rs 960 as there weren’t many active buyers for it. Since the bond is now quoted at Rs 960, there was an unrealized loss of Rs 15 for fund “X” too. But, instead of account for this unrealized loss, the liquid fund “X” kept its valuation unchanged assuming that it will be able to redeem the bond at face value on maturity. Later, an independent rating agency slashed credit rating of this bond, following which the price fell further by Rs 50. Fund “X” still didn’t bother to factor in these changes.
  • By now, it had created a speculation of a potential default. This triggered massive redemptions from the liquid fund “X” since everybody knew that fund “X” had 15% of its portfolio weight invested in a bond of troubled company. To provide liquidity to investors, fund “X” had to sell other good securities in its portfolio too. Eventually, the issuer of the bond defaulted and fund “X” incurred massive loss. Had the fund factored those unrealized losses as done in mark to market valuation it would have reduced the extent of its losses.

Stocks with Highest Allocation in Equity Mutual Funds

Introduction

In this article, we are going to see the 10 most favourite stocks of mutual funds considering data as on August 2019. These 10 stocks are having highest allocation in equity mutual funds.

10 Most Favourite Stocks of Mutual Funds

• As far as the equity oriented mutual funds are concerned (funds having equity allocation), the total AUM as on August 2019 is around Rs.10.31 Lakh Crore.
• This AUM of Rs.10.31 Lakh Crore is contributed by :
  1. Pure Equity Funds
  2. Hybrid Oriented Funds (with Equity allocation)
  3. Index Funds
  4. Index ETFs
  5. Sectoral Funds
• It means the above all type of funds have made investments in stocks worth of Rs.10.31 Lakh Crore in stocks.
• Indian Mutual Fund industry’s Average Assets Under Management (AAUM) stood at Rs.25.64 Lakh Crore in August 2019. So we can see, around 40% of the total AUM of the entire mutual fund industry is contributed from investments in stocks.

Which are the top 10 stocks contributing to this 10.31 lakh Crore AUM?

Not surprisingly, out of these 10 stocks, 6 stocks belongs to banking and financial services sector (3 corporate banks, 2 retail banks and 1 housing finance company). Out of the rest 4 stocks, one company each from IT, construction and Engineering, FMCG and diversified conglomerate.

1. HDFC Bank

• HDFC Bank is the stock having highest allocation in total mutual funds portfolios with equity allocation.
• Around Rs.71,142.1 Cr is invested in HDFC bank by all mutual funds. So, if we consider the total AUM of Rs.10.31 Lakh Crore, HDFC bank alone is holding almost 6.9% of total equity AUM of all the mutual funds. It shows the confidence all the mutual fund houses is having for HDFC Bank.
• HDFC Bank is a Retail-oriented bank. It has given the profit growth of almost 20-25% y-o-y since last 10 years, having a great consistency in profit growth numbers. For the same reason, HDFC Bank has been enjoying a premium valuation in the market.

2. ICICI Bank

• ICICI Bank is the second highest stock in terms of allocation by mutual funds in their portfolios.
• Mutual funds have made a investment of around Rs.59,465.4 Cr in ICICI Bank out of total Rs.10.31 Lakh Cr equity investment. Thus, ICICI Bank is holding 5.7% share in total equity mutual fund AUM.
• ICICI bank is a corporate bank. The NPA pressure of corporate banks from last 2-3 years is now fading down slowly. The profits of corporate banks are going to be promising in coming quarters. And with the improved earnings, Earnings per share of corporate banks and overall Sensex and Nifty Indices can go up in future. Thus, with these improved EPS numbers, price-to-earnings ratio can be rationalized in course of time.

3. Infosys Ltd.

• Infosys is the only one IT stock in 10 most favourite stocks held by mutual funds.
• It might be because of the higher percentage of promoter holdings (72.05%) in case of TCS. The free float market capitalization of TCS is very small. As a result, there is very little scope for the domestic institutional investors (DIIs) like mutual funds to buy the stock (TCS) and include it in their portfolios.
• On the other hand, in case of Infosys, promoter holding is only 13.15%. So there is very good scope for mutual funds to buy the healthy growth delivering IT stocks like Infosys. The total investment in Infosys is almost Rs.44,960 Cr with 4.3% allocation in total equity oriented funds AUM.

4. Reliance Industries Ltd.

• Reliance Industries Ltd (RIL) is a diversified conglomerate company. Equity mutual funds are having a consistent allocation in RIL.
• Since last 2-3 years, allocations in RIL have seen a decent growth with the current holding of Rs.40,312.3 Cr by equity oriented funds. This allocation in RIL contributes around 3.9% of total AUM.
• Reliance Industries stock is trading at a PE 19.31, which is higher than its 3 years, 5 years, 10 years average PE ratio. With the improved earnings visibility from Reliance Jio and Reliance Retail, RIL is enjoying a premium valuation. Jio and Retail both the businesses are going at fast pace and both can come with IPOs in coming years.
• So, due to the very high free float of RIL and higher earnings visibility in future by the stock, equity funds are buying RIL and trying to increase the allocation of the stock in their portfolios.

5. Larsen & Toubro Ltd.

• L&T is a construction and engineering conglomerate player. Mutual funds are invested around Rs.33,281.3 Cr in L&T stock. While the % allocation of L&T is around 3.2% of entire equity AUM.
• L&T is a very good stock in terms of corporate governance, consolidated businesses growth(Financial Services, IT). L&T is delivering a consistent growth in its profits over the years. And therefore, it can be a good bet for the investors to hold the stock for their long-term portfolios.

6. State Bank of India

• SBI is the biggest bank of India not by market capitalization but from business point of view in term of credit/loans given in the market. The investment in SBI is around Rs.33,066.2 Cr by mutual funds with 3.2% allocation in the stock out of total equity exposure by mutual funds.
• Just like ICICI bank, SBI is one of the corporate banks with high earnings visibility. With the decrease in the provisioning (kept aside for NPAs from operating profits earlier), the profitability of the bank is increasing and will improve even more in coming quarters. So we can say that SBI is coming out and relieving from NPA pressure slowly.
• The current profitability of all corporate banks, which is around Rs.4,000 Cr will grow to almost Rs.80,000 Cr by FY2020-21. So we can clearly get the growth trend for the stock in future and this is the

7. HDFC Ltd.

• HDFC Ltd. is focusing on the housing demand in ‘Affordable Housing’ segment. It has a great opportunity in housing finance after the merger of Gruh Finance and Bandhan Bank.
• The company is having a consistent growth potential to deliver the profit growth in coming years. So, Domestic Institutional Investors like mutual funds are very positive about HDFC Ltd. The current holding in HDFC Ltd is around Rs.31,521.9 Cr, with almost 3% allocation in the total equity AUM of mutual funds.

8. Axis Bank

• Axis Bank comes under the corporate bank segment. Equity oriented mutual funds have invested around Rs.30,326.5 Cr in Axis Bank. The stock is having 2.9% allocation in entire equity AUM of mutual funds.
• Just like other corporate banks ICICI Bank and SBI Bank, the earnings visibility of Axis Bank is improving in near future due to the reduced NPA pressure. And in the revival phase of corporate banks, we believe Axis bank is running ahead of ICICI Bank and SBI Bank. So it is a very good opportunity for mutual fund houses.

9. ITC Ltd.

• ITC Ltd is a FMCG conglomerate company. The current holding of ITC Ltd is almost Rs.28,105.7 Cr, with the % allocation of 2.7% by the mutual funds of equity orientation.
• The major contributors are the Index funds and Index ETFs in this allocation of 2.7% for the stock. Because of high free float of the stock, it is mandatory for the Index funds and Index ETFs to have the allocation for ITC Ltd. Moreover, ITC Ltd is having a good weightage in the Sensex and Nifty indices which is beneficial for the stock to increase its holdings by the index funds.

10. Kotak Mahindra Bank

• Kotak Mahindra Bank is the one of the best banks in retail banking. It is a well-managed bank, with a great vision for future growths.
• Mutual funds have made a investment of around Rs.59,465.4 Cr in Kotak Mahindra Bank. Thus, the bank is holding 2.3% share in total AUM of equity-oriented mutual funds. And this allocation have seen a consistent growth by the mutual funds.
• As we all know, the promoters are required to reduce their holding as per the RBI’s regulations. So in this scenario, DIIs like mutual funds are very positive to increase their holding in Kotak bank once the free float will be available in the market.

Mutual Fund Investors Should Not Do These 4 Things in Current Volatile Markets Scenario

Introduction

Indian stock market is currently going through a correction phase. In this article, we will discuss the 4 things to note for mutual fund investors in current volatile markets in order to generate higher returns.

Volatile Markets : 4 Things To Note For Mutual Fund Investors

Lets discuss the which are those 4 things to note for mutual fund investors in current volatile markets.

1.Do Not Focus Too Much on Current Market Scenario

• Indian stock market has entered a correction since last couple of weeks due to lack of measures in the budget 2019 to stimulate the economy. Also, taxation on the super rich has adversely affected the foreign investments and soured the market mood.
• The Indian equity markets is going through a slow down due to both internal and external factors. Following are some of the factors/reasons behind the slowdown.
  1. Internal factors : NBFC crisis, Slowdown in auto sales, consumption and manufacturing
  2. External factors : US China trade, Brexit, uncertainty in crude oil prices, overall slowdown in global economic activity
• Thus, you should not take your investment decisions in this kind of current scenario in the stock market. You should always remind yourself one important thing that you are investing in the stocks to achieve your long-term financial goals.
• So, you should not focus on or worry too much for the short-term volatility and sentiment in the current market scenario.

2.Do Not Stop Your SIPs

• SIP route helps you average your purchase price and helps you with better returns with relatively lower risks. This rule applies for all Equity SIPs.
• When market sentiments start becoming a bit panic or unshielded, most of the investors start worrying about their regular investments SIPs and raising a question on continuing their SIP investments. But, stopping your SIPs would not be a smart move.
• The investors who would continue with the SIP investments during the market slump would gain by buying more units of the same fund. It helps them to buy stocks at a discount. Hence those investors who stick to their SIP investments would gain significantly through a lower average price of holdings.
• So, you should not stop your SIPs in current market scenario in order to get the advantage of stock purchases at the discount.

3.Do Not Change Your Original Investment Allocation

• Most of the investors tend to change their investments in times of market volatility. 
• The BSE Sensex is trading lower compared to the 1-year-ago and 3-months-ago levels, while it is flat compared to its level 6 months ago.
  • In the past one year, small cap and mid cap funds have offered negative returns of almost -16% and -12%, respectively.
  • Thus, many investors tend switch to large cap funds to be safer if mid cap and small cap funds are not showing the expected performance. But that is not a right move.
• Keep on altering the original investment allocation would affect your investments and can hamper your long-term returns.
• Don’t think about changing allocations, moving to safer schemes etc. The best thing to do is to do nothing, in such uncertain, volatile market conditions. So, Stick to your asset allocation.

4. Don’t Be Too Excited

• Many smart investors make strategic allocations in a falling market to maximize wealth. Such tactical allocations will definitely helps you to buy more in a sluggish market.
• An aggressive investor is prepared to take higher risk in anticipation of higher returns. Many times, you tend to go overloaded in the sentiment of becoming too excited in falling markets.
• However, you should allocate your surplus funds to make strategic investments only after thinking it through. Allocate only the part you do not need in a short term.
• Don’t be too excited for profit booking by going overloaded in sluggish markets. The market may not move as per your expectation and you might incur losses in the process.

Comparative Analysis of Value vs Multicap Mutual Funds

Introduction

In this article, we are going to do a comparative analysis of Value Funds Vs Multicap Funds, based on the parameters such as market capitalization, sector allocation, returns (calendar returns, trailing returns, rolling returns) and risk ratios etc.

Value Category : Value category funds follows value investing strategy for stock picking and it may or may not follow multicap approach for stock selection. Basically, value stocks are the stocks which are traded at relatively low price as compared to peers and they have low PE.

Multicap Category : Multicap category funds can invest across market capitalizations as there is no specific mandate as such but minimum 65% investment has to be equity. Multicap category mostly have growth oriented stocks. It can have value stocks as well.

Value Funds Vs Multicap Funds

In order to select between value fund and multicap fund, we have given comparison of category average in terms of market capitalization, sector allocation, returns – calendar, trailing, rolling and risk measures – alpha, beta, standard deviation and PE.

Following is the list of multicap and value funds which we have considered for comparison.

Market Capitalization

Both the categories have almost same allocation in midcap and cash, difference is in allocation in large and small cap. Multicap category has higher allocation in large cap and lower in small cap as compared to value category. Value category’s high allocation in small cap is due to the approach it follows. Multicap category is more inclined towards large cap. Value category funds are more aggressive from that perspective. They have more mid and small cap allocation as compared to multicap.

Sector Allocation

It is interesting to know that both the categories are very bullish on financial sector. Multicap has significantly increased its allocation in financial sector from 24% to 34% in last 5 years. Value category has also significantly increased its financial sector allocation. There is slight or no change in allocation in construction and FMCG sector. Value category has increased its allocation in energy sector while multicap has decreased and both have decreased in technology sector. Overall, there is not much difference in sector allocation.

Returns

Types of mutual fund returns is as follows :

Calendar Returns

Calendar returns are nothing but the absolute returns calculated from 1^st Jan to 31^st Dec.  It shows if the fund is able to contain losses better than the index. There is not much difference between calendar year returns of multicap and value category in most of the years. Till 2016, both the categories have beaten benchmark. In 2017, Multicap category was beaten by both value category as well as benchmark. In last 11 years, 2018 was the worst year for both categories. Overall, they have performed consistently and very similarly.

Trailing Returns

In last 1 year, multicap category has done much better than the value category because of more allocation in large cap. Value category could not perform well because of its aggressive investment across market capitalizations. Small  and mid-cap space has not done well in last one year. In 3, 5 and 10 years, there is hardly any difference from the returns perspective. Both have outperformed the benchmark in long term.

Rolling Returns

Rolling returns of the fund show consistency of fund’s performance. Again, there is not much difference in rolling returns. Value category returns are slightly better than multicap.

Risk Ratios

From the value of standard deviation and beta, we can see that there is no difference in risk profile. Both the categories take similar risk . Beta of less than 1 indicated that both are less volatile than the market. Alpha of multicap category is more because of greater allocation in large cap stocks. Value category has lower PE as expected. PE of benchmark is between that of multicap and value.

Summary

• Currently, very little difference between value and multicap category in terms of risk and returns. One reason could be that many of the value funds currently do not follow pure play value strategy.
• Even some multicap funds can have or do have value strategy. So, when planning to buy a multicap fund, you should consider both multicap and value category.