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Opinion

The Simple Point Is: Debt Funds Have Risk.

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SEBI has been pretty laid back when it came to Mutual Funds. Suddenly, it’s woken up and has been strongly pro-active in recent times. From ensuring that funds stick to their stated objectives to reducing commissions as a fund grows in size, SEBI has changed the way Mutual Funds in India operate.

When a company wishes to raise money, it has two ways to go about it. It could either issue new equity shares or raise money via Debt. While equity is the primary source at the start of any enterprise, raising money via equity is expensive since it dilutes other shareholders at every instance of new issue. Debt on the other hand is cheaper if the company is able to generate a return on capital employed greater than the interest it needs to pay on Debt.

In Debt, the company has two options.

The first is to go to a Bank and raise money by pledging assets it owns. This is the route taken by most companies even though it is expensive compared to the second option.

The second option of raising money is by selling bonds / debentures of the company. The advantage of choosing this option lies in the interest rate differential between what a company can get from Banks versus what it needs to pay on its Bonds. (And some other caveats like spreading the risk to multiple entities, the ability for a lender to sell its loans on an open market and so on)

In India, the biggest seller of Bonds is the Government of India. The Corporate Bond market is still small comparatively with only 30% of outstanding credit being sourced through Bonds. Banks still account for the majority of loans.

Traditionally Financial Institutions such as Banks & Insurance Companies were the largest buyers of Corporate Bonds most of which even today are privately placed. This is changing in recent times with Mutual Funds emerging as a major source of capital.

As per Crisil’s 2018 Yearbook, inflow into Corporate Bonds have been high from NPS and Mutual Funds. While NPS, acronym for National Pension Scheme handles a lot of long term monies of investors, Mutual Funds whose funds are more short term in nature for they could be withdrawn any day have been aggressive as well.

Banks Versus Mutual Funds

Banks when they issue loans directly or indirectly to corporates have a cushion – if a corporate defaults, the fact that they have a good differential in borrowing costs vs lending means they can absorb the bad debts without it having to impact the depositor.

Effectively, the bank takes the risk of default on its own. Only if it fails completely does a depositor get hit – and our banking system hasn’t seen failures (at least in commercial banks)

Mutual Funds on the other hand are more of a pass through vehicle. The investors gives a mutual fund money. The fund invests in corporate bonds. If the bonds default, the hit is taken by the investor, not by the mutual fund. The only reason funds are being preferred over Bank Fixed Deposits being the slightly higher return combined with Tax savings.

(Interest received by mutual funds is exempt from taxation – the mutual funds themselves don’t pay tax. and if the investor doesn’t sell the fund itself he pays no tax. The investor can thus defer paying tax on interest for many years, until he gets the benefit of long term indexation of inflation – which can reduce the tax rate to as little as 5% of the profit effectively)

While the recent spate of bad loans may make it seems that Banks give out loans without much understanding of the risks involved, the fact is that most Banks have very strong Credit monitoring teams which look into major factors before large loans are given to any company. (Ok, they are supposed to do better, but at least they have a team)

Many a mutual fund on the other hand have not that much expertise in credit risk with very few having teams that monitor the state of investments at a very close level. A bank may, for instance, have access to CRILC data which tells it if a corporate has defaulted to other banks – a mutual fund does not. A bank may be able to track a company through the relationship of a local branch manager. Instead, mutual funds may choose to use the simplest short-cut in town – the Credit Rating Agencies rating of the company.

This is sometimes an easy way out. The rating issued by a Credit Rating Agency is just an opinion and comes with no guarantees. As we have seen recently, companies that were rated AAA – the highest notch any company can go defaulted & was immediately downgraded to D.

But for those who had bought papers assuming that it was really a AAA company, there is no exit once the penny dropped – default or otherwise. For instance, DHFL hit the negative headlines in September of 2018. Yet, it didn’t default on any interest or principal payments until June of 2019. (and even then, only for four days)

But if you were a holder of the NCD’s issued by DHFL, there was no market for the same – at least not without having to take a large hair-cut. Once again, DHFL was a AAA rated company as recently as May 2018 when it raised nearly 6000 Crores by issuing Non Convertible Debentures – the same Debentures that recently defaulted its interest payment and hence saw debt funds of MF’s take a large cut in their NAV’s.

The easiest thing when we see such things is to blame the Rating Agency – after all, what is the worth of a rating if bonds of companies that are sold for 3 years default just one year into their tenure.

As much as Credit Rating agency would want to point out that they provide just an opinion, the weakness of such an excuse is that a poor rating is also a reflection of the lack of adequate understanding of the company’s financials.

Unlike the case with IL&FS which went straight from AAA to D, the move was more gradual – at least in terms of the rating in case of DHFL

The Simple Point Is: Debt Funds Have Risk.

 

If you cannot trust the rating agency, how does one invest in securities where liquidity is poor and chances of exit once some-one has cried out “Fire”? This is close to impossible.

Basically, if you want to be in “highly rated” bonds, then once a bond is downgraded, you can’t sell it.

But since everyone else also wants to be in “highly rated” bonds, there’s no one to buy it. The downgrade makes the bond illiquid, and now you have to hold and hope that they don’t default.

What is interesting is that while International Rating agencies rate India at BBB- (the same rating which DHFL had shortly before it defaulted, we have a whole load of companies that seem to be doing so spectacularly that they are rated at AAA.

In US, only two companies – Johnson & Johnson and Microsoft that carry a AAA rating. In India, CRISIL alone has 155+ companies with AAA rating. Either our companies are amazingly stable entities or our ratings lack the rigor. Of course, US didn’t have this low a number even a decade ago, but the financial crisis brought to reality the weakness of the rating system and post that, the number of companies which have a AAA rating have literally plummeted.

The Confusion – Perhaps Deliberate – of Safety in Debt Funds

The name of the Game when it comes to Asset Management is Asset Under Management. The bigger you are, the better for fees are charged as % of the total money that is managed. With 40+ AMC’s and ‘n’ number of schemes which raised monies, it was always tough to deploy them safely with even the so called AAA companies.

The “Mutual Fund Sahi Hai” campaign kind of instituted that Mutual Funds were safe (of course, there is always a disclaimer, but whoever really reads the fine print) and give the tax arbitrage compared to Fixed Deposits, Debt funds were sold as being as safe as FD but one that gives higher return.

Cooperative Banks offer a much higher interest rate compared to scheduled banks and yet we don’t see investors queuing up to deposit their money for they realize that the risk present with Cooperative Banks.

When it came to Mutual Funds though, such thought process weren’t applied nor were they properly educated. Instead of the long disclaimer that accompanies a debt fund, a simple disclaimer that you can stand to lose capital with debt funds may have been enough to ensure that investors who were looking for safety did not invest in funds that in turn invested in risky corporate bonds.

Better Returns: Not Better Quality

The only way to garner more funds is by showcasing a higher return in the funds they manage. Swing for the fences is not really what the fund manager would have thought but by going down the ladder in terms of quality of bonds they were willing to bet investors money on, it was precisely what they have achieved.

Look at the rating of bonds issued over recent years. AAA has decreased while un-rated and AA bonds have increased as a percent of the total. Do note this is the case period when there has been a huge rise in the Assets Under Management and hence the total sum of money risked has shot up substantially.

The Simple Point Is: Debt Funds Have Risk.

One reason for fund managers willing to bet lower down the order has been the very low default rates even in bonds that have been rated AA or below. Look at the picture below from Crisil which shows the low probability of default.

 

The Simple Point Is: Debt Funds Have Risk.

When shit hit the fan so as to speak, Mutual Funds across board have suffered and this suffering has been passed on to the Investors.

From HDFC to Franklin to DSP to the Tata’s, every major fund house has taken a synchronized hit like they had never before. Suddenly, Debt didn’t really appear as Risk Free as it was sold as to be.

While its true that investors have a short memory, the losses are real and has already impacted inflows into funds. This has been a wake-up call not only for investors but also SEBI.

New Norms: Short Termers Can’t Take Credit Risks?

Yesterday’s Business Standard has an article that claims that SEBI may rework the current categorisation norms to mitigate risk in medium- and shorter-tenure debt mutual funds (MFs) that take credit risks.

While we have no knowledge of whether SEBI will actually go about implementing the same or is this more of a test the water, it’s a start either way in terms of actually defining what a Debt fund is all about and its suitability.

The key focus is on the kind of papers that are bought by Mutual Fund houses. If the report is anything to go by, SEBI wants to mandate that 70 – 75% of funds should be with Bonds that have a AAA rating.

As much as the thought process goes, this is good – but as the saying goes, there is always a slip between the cup and the lip and once one starts to think about the execution process, we find the same faults that have contributed to what we find ourselves currently in.

The underlying rationale behind this move seems to be an effort to ensure that short to medium term funds don’t suffer credit risk. Good thought but as we have seen recently, the problem is of 2 fronts

One, there is really not enough AAA rated paper to satisfy the needs of all Short Term Mutual Funds.

Second, what does one do when a AAA rated paper is downgraded? Given that most fund houses will have little extra space, who will buy those papers once its being downgraded and needs to be removed from one’s portfolio.

Let’s assume that SEBI doesn’t compel fund managers to sell out when a fund is downgraded, this again creates a bias with regard to the starting point. If you are great when I buy, I don’t have to care a damn about what happens next.

Nearly 2 years ago, SEBI decided that each fund house can run only one fund within the category to which it belongs. In the true spirit, only two types of funds can take credit risks – the first being the credit risk funds and the second the corporate bond funds.

But these funds are sold to investors who understand or are supposed to understand the risks involved for the gains can be higher too. Credit Risk funds for instance returned 10%+ on an average in 2016.

Get Them Educated Instead – Debt Funds Have Risk

The problem with SEBI’s approach is simple – its a band-aid at best for what happened with DHFL or IL&FS is bound to repeat in time. Instead, it’s better that the focus shifts to educating the investor of the Risks he should know about when investing in Debt Funds.

HDFC AMC has today announced that it will take on its books the zero coupon bonds that defaulted on payments. We had written about the issue here. We had in the past seen a similar move by Franklin Templeton took over the bonds of JSPL which had been downgraded.

As much as this move was welcome, the fact is that not all AMC’s and even HDFC for that matter can take up losses of Bonds. Most of it needs and will be passed onto investors. (More on this on a separate post)

Today, the way investors think about debt funds is that its equivalent to bank deposits. That needs to change – while debt funds may not be as risky as equity funds when it comes to draw-downs, the fact is that its a risky product.

Most funds today carry a chart to depicts the level of Risk. The chart below is for an Ultra Short Term Fund. But what does “Moderate Risk” even mean?

The Simple Point Is: Debt Funds Have Risk.

Does it mean, there is Risk of earning Interest on the capital deployed or Risk of losing part or whole of the capital deployed. We need better way of showcasing to clients the risk that they need to bear with products. Blaming the Fund Manager, the AMC, the Credit Rating Agency, the Media, SEBI  among others may make it feel good but ultimately it seems that “Caveat Emptor” applies here as it does everywhere else. As an investor, you need to be aware of the Risks.