Read this, before you invest!
9th July 2020
Dear Readers,
This topic has become all the more relevant now that FD returns are at decadal lows.
Not too long ago debt mutual funds & corporate debentures were rampantly sold to investors as fool proof alternatives to bank fixed deposits.
Investors were promised risk free returns of 8-10%, sometimes more, with an indexation benefit after 3 years that resulted in an effective tax rate of 10% on long term capital gains.
Skeptical investors were shown track records of funds delivering on the above promise. A fantastic product for HNIs & corporates looking to reduce their tax burden and park surplus funds.
In the finance world though, ‘risk free’ is not a term to be taken lightly. Any worthwhile investment that aims to generate surplus returns for an investor does involve some element of risk albeit to a varying degree depending upon the type of investment. Identification & understanding of the risks goes a long way in successfully being able to generate surplus returns while protecting capital.
In the case of debt funds the risk to the principal and interest are real and quantifiable. An understanding of these would help an investor better appraise his investment choices.
In this post we talk about 5 key risks involved in debt investments.
Credit Quality Risk
A debt mutual fund manager buys on behalf of the investor many bonds & debentures issued by various companies. The regular interest payout on these bonds and debentures constitutes to the stability of the returns generated by the debt mutual fund scheme. But what happens when a company is unable to pay the interest on the issued debentures? Or worse yet, it is unable to pay the principal amount used to procure the debentures in the first place. In such a case, the debt fund scheme has to write off the investment and mark down the NAV of the scheme to the extent of that investment, resulting in a loss to the investors.
Does it not then, become vital for an investor in debt funds to study all the underling holdings of a the debt fund?
Let us take the case of Franklin Templeton’s India Credit Risk Fund. An out-performer in returns for the past several years which had to be unceremoniously wound up (https://bit.ly/2O9fam0).
When an investor bought a unit of Franklin India’s Credit Risk fund, he was essentially investing his money in all the above securities held by this mutual fund scheme.
From the above table we are able to understand two things: firstly how the fund was able to generate superior returns compared to its peers? and secondly, why it had to be wound up?
When we look at the underlying holdings of the fund we understand that the fund had invested heavily in relatively lower rated papers to generate superior returns (The rating is giving by credit ratings agencies such as CARE, ICRA, CRISIL etc, based on factors such as earnings potential, balance sheet integrity, sectoral outlook etc). Lower the quality of the rating, higher the interest payout by the company to entice fund mangers to purchase its debentures.
When subject to a stressed economic climate the underlying companies were not able to payout the stipulated interest resulting in defaults and write offs which ultimately resulted in losses for the investor. When investors hurried to redeem their investments the fund was unable to generate the necessary liquidity and had to be wound up.
A debt fund with high credit risk is certainly not an alternative to a fixed deposit, it is for sophisticated debt investors who understand the degree of credit risk involved versus the return generated.
If an investor feels one can solely rely on the credit rating of credit rating agencies to assess the credit quality of a fund, think again. ILFS, DHFL, Reliance Power, Yes Bank etc. all had respectable credit ratings by multiple credit rating agencies before they defaulted.
Interest Rate Risk
While credit quality risk can be minimised or eliminated by investing in government/state backed bonds, gilt mutual funds & other high quality AAA+ rated papers, are these investments risk free?
The short answer is No, these are not risk free either.
The bond price is highly sensitive to the prevailing interest rates in the market (depending upon the duration to maturity). For example if an investor buys a bond with face value of INR 100, 8% coupon rate, and a maturity of 7 years and the prevailing interest rates go up to 9%. Then the investor will have difficulty in selling his 8% coupon rate bonds to other investors who would now prefer 9% bonds. To overcome this problem the investor with the 8% bonds would have to sell the bonds at a discount to the face value, roughly rupees 90 in this case to make them equally attractive to the 9% bonds causing him a loss of 10% on his investment.
This phenomenon is often observable when the reserve bank of India hikes or cuts interest rates (depending upon its monitory policies) causing the prevailing rates in the market to go up or down.
The degree to which a bond price falls or rises is governed by the duration to maturity. In other words, bonds with a longer tenure are much more susceptible to interest rate risk than bonds having shorter maturity dates.
In the example below we can see that frequent rate cuts by RBI in order to stimulate the economy has made gilt fund holders great returns. One should bear in mind that the opposite would also hold true in case the RBI decides to hike rates.
Reinvestment Risk
Reinvestment risk refers to the possibility that an investor will be unable to reinvest cash flows from an investment, at a rate comparable to their current rate of return. This risk is especially prominent in callable bonds.
Callable bonds have no fixed maturity date and the issuer of these bonds is at the liberty to call them back at anytime when he feels capital can be re-raised at a lower cost.
At present ‘perpetual bonds’ which are callable, are being sold to investors as high yielding safe investment alternative to FDs. However investors need to fully acquaint themselves with the risks before investing in these.
The table below outlines some of the callable bonds available in the market today.
While these look attractive at first sight, realising the risks associated with these bonds will make investors give them a second thought.
For the start, the banks issuing these may at any time skip the interest payouts or permanently write down the principal if the bank’s capital ratio falls below a defined threshold. The recent case of Yes bank defaulting on the repayment of AT1 bonds (aka ‘perpetual bonds’) lost investors roughly INR 11,000 crores. Though SBI’s decision to infuse capital in Yes Bank may be a breather for the deposit holders, there would be little to no respite for holders of AT1 bonds who are likely to lose most of their investment.
The banks can call these bonds back at anytime (even before the call date) if they find cheaper ways to raise capital, conversely the banks (in theory) could also not return the principal and keep paying the interest payouts by not deciding to call their bonds back.
Concentration Risk
As the famous saying goes, to not put many eggs in one basket, A debt mutual fund having a large exposure to debt papers of one particular company or a few companies raises the concentration risk of an investment. If a company with a large exposure were to default the fund’s NAV would be written down to that extent. A mere 3-4% default in a debt fund would place its returns below those earned in a bank fixed deposit. Concentration risk increases when there are a lack of good investment options for debt fund managers to choose from. A simple study of the underlying holdings of a fund can give an investor an idea of the concentration risk involved.
Illiquidity Risk
Though investors are often informed that they could (even) exit closed ended debt funds by selling them in the secondary market, this may not always be as easy as it sounds.
Bonds & close ended funds unlike stocks are sparsely traded in low volumes in the secondary market. So finding a buyer for your debt securities could prove to be a challenge, making your close ended investment illiquid. Even if an investor is lucky enough to find a buyer in the secondary market he may only be willing to purchase the debt securities at a discount to the face value.
Once the investor is aware of all the above risks, he is in a better position to take a call on switching his/her Fixed deposit’s to debt instruments such as debt mutual funds, govt. bonds, corporate debentures etc. It is the duty of an investment manager to adequately inform his client of both the benefits and the risks involved in an investment.
SEBI Disclosure: This report is not a recommendation to buy or sell any funds or provide investment advice. Investors are requested to conduct independent research or consult their Registered Investment Advisors for advice. Prosperity Wealth Management Pvt. Ltd. will not accept any liability for any investment decisions made based on this report. Prosperity Wealth Management does not guarantee the accuracy of any information provided herein. Copyright 2020.