Category Archive : Debt Funds

Returns - Credit Risk Funds

Credit Risk Funds Analysis | Comparison with Conservative Hybrid Funds

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?

Mutual Fund Reviews by Invest Yadnya
Mutual Fund Reviews by Invest Yadnya

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
 Comparing Returns - Credit Risk vs Short Duration Funds
Credit Risk Funds Analysis – Comparing Returns of Credit Risk vs Short Duration Funds
  • 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
 Comparing Credit Quality - Credit Risk Funds vs Conservative Hybrid Funds
Comparing Credit Quality – Credit Risk Funds vs Conservative Hybrid Funds
  • 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 - Regulatory Changes in Debt Funds

Regulatory Changes by SEBI in Liquid, Overnight Debt Funds During FY2019-20

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

SEBI Circular - Recent Regulatory Changes in Debt Funds
SEBI Circular – Recent Regulatory Changes in Debt Funds

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.
Exit Loads for Liquid Funds
Exit Loads for 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.
Mutual Fund Detailed Reviews by Invest Yadnya
Mutual Fund Detailed Reviews by Invest Yadnya
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.

Repo Rate – Interest Rate – Debt Fund NAV coupling effect

Changes in interest rates can have both positive and negative effects. When Reserve Bank of India (RBI) changes the rate at which banks borrow money, i.e the Repo rate, this has a connecting and spreading effect across the entire market.

These interest rates also affect debt fund prices (their NAVs). There is an inverse relationship between debt fund prices and interest rates, meaning that as interest rates rise, NAVs fall, and as interest rates fall, NAVs prices rise.

One way that governments and businesses raise money is through the sale of debts. As interest rates move up, the cost of borrowing becomes more expensive. This means that demand for debt funds will drop, causing their NAVs to drop. As interest rates fall, it becomes easier to borrow money, and many companies will issue new debts to finance expansion. This will cause the demand for debt funds to increase, forcing NAVs to rise.

For Example,

Lets us assume that Mr. Sachin bought a 7 year bond having Face Value (principal) Rs. 1000 with interest rate 10%. After 2 years, Mr. Sachin wishes to sell his bond. But, the other bonds in the market currently have an interest (coupon) rate of 12%.

Here, Mr. Sachin will have to sell the bond at discount. The price at which a buyer will buy the bond is the price at which the bond will yield 12% returns. Therefore, the face value of the bond will come to approx. Rs. 910. A loss of Rs. 90/bond will be incurred and this exactly the effect of interest rate on NAVs of debt fund.

Interest Rate Coupling effect

Similarly, exact opposite would have happened if the interest rates would have decreased to say 8% where the face value would have become approx. Rs. 1080 and a profit of Rs. 80/bond would be received.


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