By Balachandran R
When equity mutual funds dropped precipitously along with the stock market over the last two months, the news did not make any major waves. But Templeton’s shocking move to lockdown six of its debt mutual fund schemes, made for screaming headlines. This is because of our mistaken notion that debt funds provide steady returns, with principal never at risk.
Templeton’s strategy was all along set up for failure. Running an open-ended scheme while investing largely in low grade, illiquid investments with the objective of earning higher returns than most peers, is a prescription for disaster. The only surprise is that it took this long to implode. The coronavirus pandemic merely acted as a catalyst. Expect more markdowns from other AMC’s in credit risk funds and other schemes carrying low grade investments, but hopefully not to the extent of the Templeton meltdown.
What next for fixed income investors?
Fixed income investors who seek 100% guaranteed return of principal, should stay away from debt mutual funds. For investors in lower tax brackets, a small window may be available to invest in 7-year government taxable bonds carrying 7.75% interest, which today is one of the best investments, though it’s not certain if this will be available for long, given today’s low interest environment.
Investors in higher tax brackets may not have much choice except to grit their teeth and continue with debt mutual funds, given their very attractive tax breaks.
Here we try to arrive at a curated list, for the benefit of such investors.
Banking and PSU debt funds
Banking and PSU debt funds provide a modicum of safety. Let us apply the following criteria to identify which scheme to choose as most fund houses have an offering in this space:
1)Backed by the big three: SBI, HDFC or ICICI.
2) No exposure to fragile private sector banks or AT1 bonds from public/private sector banks. The Yes Bank disaster would still be green in the memory of investors.
3) No NBFC paper. While an investment in HDFC may be understandable, it is outrageous to see some banking/PSU debt schemes investing in finance company instruments, which trade at almost distress levels in the secondary markets. Investors should weed out such banking and PSU debt schemes from their portfolio, if the fund managers have recklessly invested in shaky finance companies.
4) No securitisation exposure even if rated “AAA”. These can be simple (retail PTC’s) to complex structured deals involving very large blue-chip corporates, selling their receivables to mutual fund investors through a Trust structure. Investors are at the mercy of credit rating agencies for assessing the risk, given the complexities. Credit ratings have largely become meaningless, with “AAA” ratings in the past for all and sundry, including ILFS, DHFL and Yes Bank AT1 bonds. As a consequence of such egregious cases, many investors tend to view all ratings with suspicion, even if well analysed and performed with diligence by the rating agency.
Retail PTC’s may be the next to sting investors badly, as the truck operators etc who owe the underlying obligations are in no shape to honour them, for now. The originator even if it is an acceptable credit risk, has no bottom line to the investor, having sold down its risk on truck operators to us, the mutual fund investor.
Applying the four criteria listed above throws up not a single scheme!
Relaxing some of these criteria to make the best out of a bad situation, brings us to DSP, IDFC and Axis mutual funds with a reasonably clean portfolio of banking and PSU debt schemes with yields of about 6-6.2% post expenses for direct investment.
The analysis is based on the March 2020 portfolio. Given the insatiable appetite for risk that the industry has (on our account, not theirs!), there is no guarantee that a dubious finance company or real estate company’s paper would not creep in after the latest March disclosure. However, the track record of these three banking and PSU debt fund schemes appears reasonable till now.
If the Templeton fiasco leads to large scale redemption of debt mutual funds, it will exert downward pressure on prices of corporate securities, with corresponding fall in NAV of mutual fund schemes including banking/PSU debt schemes as witnessed on Friday March 24th. Therefore, this small curated list of schemes too carries risk, even if their fund managers continue to stick with “safe” investments.
It is not clear how RBI’s liquidity window opened on April 27through banks will help mutual funds incrementally, as banks are already awash with Rs 7 lakh crore liquidity. It may just be a morale booster for the beleaguered debt mutual fund sector, with poor quality securities in their portfolio seeing neither buyers nor acceptance as collateral by banks.
Investing in government securities (G secs) have offered phenomenal returns over the last couple of years on account of fall in interest rates. They carry virtually no credit risk, though state government gilt securities may cause some concerns, compared to the safety of the central government’s securities.
Almost all gilt funds have long duration making them prone to massive losses if interest rates rise. This can happen if inflation shoots up or if there is an excess supply of government securities. Today there is a tug of war between demand destruction(deflationary) and supply squeeze (inflationary). Even if supply eases, the projected deficits of both the centre and states and massive liquidity in the system (Rs 7 lakh crores recently) can be inflationary when the economy revives. This in turn can lead to sharp increase in interest rates and huge losses to long duration gilt fund investors. Alternatively, if demand craters along with inflation, long duration gilt funds can continue providing windfall returns. Depending on the post-Covid world getting into a deflationary or an inflationary scenario, gilt fund investors stand to make or lose money!
(The writer is a fixed income investor and erstwhile corporate banker.)