Credit Downgrade or Default Risk in Debt Mutual Funds – What are the alternatives?

If you are debt mutual fund investors, then you may be aware of the news circulating for a few months with respect to certain companies credit downgrade or default in payment.

As of now, as per my knowledge, except Overnight Funds, Liquid Funds, and Gilt Funds, the majority of other categories of funds impacted to this news (few funds may not be impacted due to their exposure to such companies is NIL). This does not mean they are SAFE.

Today it may be because of DHFL, ZEE, IIFL or Vodafone but tomorrow it may be from some other companies.

You noticed that the reasons with respect to Vodafone downgrade are different than the other companies. However, at the end, it will impact the investors largely.

Credit Downgrade or Default Risk in Debt Mutual Funds – What are the alternatives?

In such a default or downgrade situation, what are the alternatives for our debt portfolio? Before jumping into understanding the available alternatives, I wish to share certain points with you.

# Credit Ratings are not constant-Yes, as you may be aware of how the credit rating changes and how it badly impacts your portfolio. Hence, never rely on credit ratings and invest.

# Never think the regulator will protect you-In many cases regulators open the eyes only when the incident happens. They tweak certain rules and then again go for sound sleep. Hence, never invest in debt funds just because there is a regulator who will take care of such default or credit risk.

# Never look for top holdings only-Many of us are under the habit of just looking at top holdings of the fund. However, your fund manager may be wisely holding certain low graded debt securities, which may not be part of top holdings. Hence, to make sure what the portfolio is, dig deep and review the complete holding of the funds.

# It is better to review the fund underlying portfolio once in a while-As you may be aware, based on the fund you have chosen, the fund managers hold the debt papers. Hence, there are situations where while investing the fund might have held all best debt securities. But later on, the fund manager might have invested in low rated papers. Hence, it is wise to cross-check the portfolio once in a while.

# Never concentrate on RETURNS alone-Never rely on just returns while choosing the debt funds. Higher returns in many cases may be due to the fund manager bet on low rated papers. Hence, a higher return debt fund does not mean the best fund.

# Never rely on STAR ratings-Exactly like credit ratings, these star ratings may also change as and when they wish. Hence, never choose a fund just because it is rated with FIVE or FOUR star.

# Your investment period must always be more than the average maturity– Many so-called experts suggest you that your investment period must match with the fund’s average maturity. However, a single default or credit risk may take more time to recover than the average maturity of the fund. Hence, make sure you must NOT follow this theory.

# Never concentrate on YTM-Many people think higher YTM (Yield to Maturity) means a higher return. But do remember that higher YTM indicates a higher risk. Hence, never be on wrong belief of concentrating on YTM.

# No Debt Fund is SAFE-Yes, it is a reality you have to understand. There was a case, where a Liquid Fund NAV dropped to around 9% in a single day (I have written a post on this and you can refer at “Is Liquid Fund Safe and alternative to Savings Account?).

The degree of risk varies from category to category. Hence, believing the particular category of the fund is risk-free means you are under wrong impressions.

# Reasons for DEFAULT or CREDIT downgrade may differ-Never be in a wrong notion that any one particular sector of companies debt papers may be risky and others are safe. Such a default or credit downgrade may happen with all sectors. Take an example of DHFL Vs Vodafone. Both are from different sectors. Both have different reasons for freefall. Hence, never be biased towards a particular sector.

After going through all the above risk factors, now you have to decide what are the alternatives for our debt part of the investment. Let me list them one by one.

1) Post Office Savings Schemes

Yes, there may be certain service-related issues. However, considering safety, I prefer these savings schemes as the best choice. It does not mean you must invest in them BLINDLY. Make sure the product may fulfill your needs. Choose wisely from the product ranges like a savings account, Term Deposits, MIS, SCSS, PPF or Sukanya Samriddhi Yojana Account, NSC or KVP.

Because Post Office Savings Schemes offer you 100% Sovereign Guarantee.

2) Bank FDs and RDs

The next level of products is Bank FDs and RDs. Open the FDs and RDs with nationalized banks rather than risky co-operative banks. Many people do in-depth research like which will offer them higher returns. Do remember, higher return again leads to higher loss.

Hence, prefer PSU Banks especially and if possible big private sector banks like HDFC or ICICI kind of banks.

3) Public Provident Fund or PPF

PPF is a wonderful long term debt product. Hence, always utilize this debt product to the maximum of your debt portfolio. Nowadays, even banks also offer you PPF and you can operate PPF online. Hence, greater comfort with better safety.

4) EPF and VPF

EPF and VPF are the best debt instruments you can consider for your retirement goal’s debt part. Use to the maximum as this product gives you safety, tax efficiency and higher returns than other debt products.

5) Overnight Debt Mutual Funds

Overnight Debt Mutual Funds are the safest debt funds among all categories of debt funds. Hence, use them for your few days to a few months’ parking requirements.

6) Liquid Funds

After Overnight Funds, the next category of safe funds are Liquid Funds. However, as I mentioned earlier the fiasco of one Liquid Fund, it is always better to be cautious while choosing the Liquid Fund. Check the underlying portfolio and take your call.

7) Arbitrage Funds

Many of us use Arbitrage Funds because of safety and tax advantage over other categories of debt funds. However, do remember that Arbitrage Funds can also hold around 35% debt instruments and another 65% in equity and equity-related instruments. Hence, be cautious on their 35% debt part.

8) Gilt Funds or Gilt Fund with 10 Years Constant Maturity

Gilt Funds simply avoid the risks of default and credit rating downgrade. However, depending on the average maturity of the fund, they are prone to interest rate risk. Hence, you may see the volatility in such funds too.

Gilt Funds definitely offers you relief from credit risk and default risk, but due to their change in the stance of the average maturity period, they may pose higher volatility. In short, it acts like a typical dynamic bond fund where the exposure is to Gilt papers. Hence, they may be volatile and if the fund manager call goes wrong, then it may impact your returns.

Hence, to avoid such things, prefer Gilt Fund with 10 years of Constant Maturity. Use this category of fund for goals that are long term like 10+ years or so.

Do remember that Gilt Funds hold around 20% in imperfect hedging to curtail the interest rate volatility.

Few points to note before selecting the recommended debt products

# Keep around 10% to 25% of your debt portfolio in Liquid or Arbitrage Fund to make sure that the fund is available easily for your rebalancing purpose of Debt to Equity.

# Consider the Liquidity issue while choosing the above-mentioned recommendations.

# Do remember that each of your debt investment products must match with your goal requirement. For example, use PPF only if your goal is more than 15 years. Same time, you can consider SSY as a debt part of your girl child education and marriage goals.

# Risk is everywhere. Even the money you are keeping in your savings account is also risky. Hence, managing the risk is the ART you have to learn.

Let me know if you have any new ideas.