IL&FS crisis: How real is the risk in debt funds?
Continue to stay invested even if your debt funds are hit by IL&FS downgrades until we know what its turnaround plan is going to be
Debt fund investors have been in a tizzy this past month over the downgrades in credit ratings of Infrastructure Leasing & Financial Services Ltd (IL&FS) and some of its subsidiaries. A total of about 33 funds (across liquid, ultra short-term bond funds, short-term bond funds, credit risk funds, etc.) had these companies in their portfolios; the cumulative value of these holdings in these funds added up to ₹ 2,308 crore as on August-end 2018, according to data from Crisil Ltd. At least three fund houses had to mark down some of their schemes’ portfolios by about 25% to 100% of the value of the underlying securities as IL&FS and some of its companies either saw a sharp fall in their credit rating or didn’t return the principal.
The short-term scrip of Infrastructure Leasing & Financial services Ltd saw its credit rating fall to a rating of D on 17 September 2018 (indicating default), down from a rating of A4 (as on 8 September) and A1+ (as on 6 August). Similarly, IL&FS Financial Services Ltd’s short-term paper’s credit rating fell to ‘D’ on 17 September, down from A4 (as on 8 September) and A1+ (19 February 2018).
According to the mutual fund industry valuation norms, rating agencies Crisil and ICRA provide scrip prices daily to all funds across all securities that funds have invested in. But when a security turns below investment grade (Bbb-rating), fund houses value securities as per their internal valuation norms.
This time, as per the industry’s consensus, fund houses marked down the security’s value by 25% when the scrips rating went below investment grade rating (Bbb-rating). The net asset values (NAVS) went down to that extent. Later, when some scrips defaulted, some funds wrote down the entire value of their holding, while a few other funds wrote down about 50%. If you are an investor in such schemes, should you withdraw?
No mutual fund is risk-free
Contrary to popular belief, debt funds are not risk-free. Though they are less risky than equity funds, debt funds too come with two kinds of risk—interest rate volatility and credit risk. The former happens when interest rates move—specifically upwards—that causes a debt fund’s NAV to move. The latter happens when an underlying instrument’s credit rating drops or defaults on interest and principal repayments.
Joydeep Sen, founder, Wiseinvestor.in, said investors haven’t yet understood the risks in debt funds. “Historically, there have been instances where if a problem occurs with any underlying security in a debt fund, either the asset management or the sponsor company bought the said troubled paper from the debt fund and paid the money back to the MF scheme. But in the last few years, this has not happened. Whether it is JP Morgan India Asset Management (Amtek Auto Ltd), Taurus Asset Management Co. Ltd (Ballarpur Industries), or in the present IL&FS case, fund houses did not take the hit on their own books. They let the scheme take the losses and that is why the NAVS in all these cases fell,” said Sen.
How to manage risk?
Although debt funds are beneficial, managing risks is tricky. A senior analyst at a foreign brokerage house said that if you do not like taking too much risk, keep your investments in credit risk funds (that invest in low-rated papers) to a minimum and invest a majority of your investments in schemes that focus on high-rated bonds (corporate bond funds). Thanks to the recent classification exercise that the ₹ 23 tril-