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5 red flags to watch out for in debt mutual funds

​Debt MFs in the limelight
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​Debt MFs in the limelight

Recent credit events like those of Essel (Zee) Group companies and Dewan Housing Finance Limited (DHFL) have once again raised the spectre of defaults and credit rating downgrades, directly impacting debt MFs that lent heavily to these entities. This need not cause panic as debt funds continue to be a safer proposition than putting money directly in corporate bonds. However, there are some red flags that investors should be aware of.

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​1. High exposure to low-rated bonds
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​1. High exposure to low-rated bonds

Many short-term debt funds have parked a large portion of their corpus in sub-AA rated instruments to bolster returns. These are often positioned as substitutes for bank savings account or fixed deposits and so are not expected to compromise on the safety aspect. Investors should be wary of such funds, unless investing in a credit risk fund—mandated to invest lower down the credit ladder—with a clear understanding of the risk it entails. Investors should stop chasing higher yields in bond funds and stick to funds with high quality assets.

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​2. High exposure to single issuer
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​2. High exposure to single issuer

Debt funds are not allowed to hold more than 10% of net assets in securities of a single issuer. However, investors should be sceptical of funds which invest more than 7% of their corpus in a single issuer, since this increases the risk profile of the fund. Investors should also be wary of sharp drop in the corpus of a scheme within a short time.

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​3. Chunk of portfolio invested in single group
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​3. Chunk of portfolio invested in single group

Investing a chunk of the portfolio in instruments issued by a set of companies belonging to the same group can also turn out to be a banana peel because incidents affecting the parent company or any subsidiaries under its umbrella may potentially have a spillover effect on the instruments of the entire group. If the aggregate exposure to related entities is high, the fund’s NAV will take a bigger hit. Sebi restricts group-level exposure in debt schemes to 20% of the net assets, which may be extended up to 25% subject to approval by trustees.

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​4. Credit rating under watch
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​4. Credit rating under watch

Investors should not merely be concerned about rating downgrades. Often, credit rating agencies review the ratings of some companies if there is a likelihood of a change in the credit profile of the issuer owing to new developments. During this period, the rating agency re-assesses the debt servicing capacity of the issuer. If the credit rating is found no longer reflective of the issuer’s financial position, it is modified accordingly. Even though placing any issuer under watch is not necessarily a precursor to a rating change, it is noteworthy when several issuers are put under review at the same time.

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​5. Falling share price of issuing entities
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​5. Falling share price of issuing entities

While weaker share prices of a company, especially one whose bonds comprise a large part of the debt fund's holdings, typically don’t influence the value of the bonds it issues, it does hurt the bond price when these are issued against collateral of shares pledged by the promoters. When the share price of the company falls sharply, the fund will be left with insufficient cover for the outstanding value of the bonds in its portfolio, thus limiting recovery and potentially taking a hit in its NAV.

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