The debacle in fixed income funds and how to void the future pain ?




It started with the default of Infrastructure Leasing & Financial Services (IL&FS), signs of trouble emerged in June 2018 when behemoth financial conglomerate defaulted on inter-corporate deposits and commercial papers (borrowings) worth about Rs 450 crore. 

Following the traces of the event, the credit rating of the company was downgraded to "D" in September 2018. 

This downgrade triggered the whole chain of defaults and downgrades in the fixed income segment. This led the regulator to tighten its norm and be on its toes to proactively look for any loose gaps in the ethics and functionality of the corporates. 

After the IL&FS many major corporates, some of those who were even the market leader in their industry followed the trails. One such example was DHFL which caused significant pain to debt mutual funds. 

Since 2018, there have been several other entities bearing the same fate. However, we won't be covering all of them as the point of concern here isn't to dig the past but to pave the way for the future. 

SEBI's move and Segregated portfolios were born.

After the fallout of IL&FS in September 2018 and subsequent volatility in the debt and money market instruments issued by NBFCs and HFCs had resulted in redemption pressures in debt mutual fund schemes. During this period, it was observed that a credit event in even one issuer/group could lead to significant liquidity risk in the entire industry which in turn can lead to further volatility in the market. Accordingly, AMFI submitted a proposal for side pocketing to the regulator on 05th October 2018. SEBI came out with circular on side pocketing on 28th December’2018.

What is Segregation? 

Simply put, it allows an open-ended scheme to quarantine a bad asset in a side cart portfolio allowing fair treatment to all unitholders and deal with liquidity risk.

What's the effect and benefit of this for the investor?

The segregated portfolio allows the fund manager to separate the pain from the remaining portfolio. Whereas the faulty bond can remain locked until its maturity and the remaining portfolio can still perform and recover the lost portion. 

As an investor, it also gives you the option to book the profit in the remaining portfolio and move our of the fund. 

For the First time Ever

Franklin Templeton Mutual Fund decided to wind up six debt funds with combined assets under management of almost 26,000 crores. It said this had been done on account of illiquid, low-rated instruments in their portfolio.

Franklin declared its month-end portfolio for March’2020, five of the six schemes which were winded up had negative cash balance. These schemes experienced unprecedented redemption pressure in the month of March and April. The regulator granted special permission for enhanced borrowing for up to 30% in two of the schemes and 40% in one of the schemes. Ultimately the fund house took the decision to wind up the schemes.

The Way Forward

Taking the learning from the whole plethora of defaults and credit events that have taken in the last 2 years, we need to formulate a strategy keeping in mind that fixed income investing has changed drastically recently and so now we need to alter our mindset and our strategy too.

The things that become a mandate to survive the pain of debt funds are basic but neglected, let's look at some points to avoid these: 

1. Stick with the quality: One simple rule of any investment is to look for the quality. The unsung practice of debt funds for a long time had been to go for the low rated paper to gain that extra return. You need to check the quality of the underlying portfolio for the fund before selecting the fund for investing. 

Always remember its fixed income investing and for that, you need to choose the portfolio that can sustain itself and its quality.  

2. High risk doesn't always mean high return: We as investors always need to remember that not all risks are the same. A credit risk category fund taking low rated security is always a better choice than a low duration and or short-duration fund taking the low rated security. This way you can be sure that you are taking a calculated risk and you have some watch over the allocation in the risky fund.

3. Strategic portfolio Allocation: Needless to say that fixed income instruments are always chosen for the purpose of safety and not to gamble or take risks, for that better option will be to go for the equity. However, this nowhere implies that now on you should completely avoid the credit risk category. By proper portfolio allocation and understanding the risk-return profile of the fund you can always allocate some amount in the credit category or fund but keep in mind to reconcile your risk-return profile with that of the fund. If the two don't reconcile, it is always better to look for other options. 

At last yes, there has been some blood in the past couple of years in the debt segment but with proper strategy and planning, you can make your portfolio less vulnerable to such pain. Debt investment are and always gonna be an important tool of financial planning and for proper sustainability of the portfolio.

Note: Views expressed above are solely the author's perspectives. Readers are advised to keep their discretion insight before making any investment. 

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