In the wake of recent downgrade of debt MFs, is it safe to invest in them?

Debt Mutual Fund How safe In the wake of recent downgrade of debt MFs, is it safe to invest in them?

ICRA had downgraded some of the debt funds of HDFC, Birla and UTI due to their large exposure to a subsidiary of IL&FS. The problem was quite unique. The IL&FS subsidiary was not exactly a cash-crunched company but had enough cash flows in its books. However, it sought protection in the blanket immunity given to the IL&FS group from NCLT resolution. This was being used by the group companies as a pretext to default on debt. In fact, the entire problem with the IL&FS crisis was that the borrowings were structured through a web of nearly 300 subsidiaries and the full extent of the default was very difficult to find out.

How did the entire crisis come about?

It is interesting to turn back and understand how this entire crisis broke out in the first place. The trigger, of course, was IL&FS crisis which first broke out in the middle of last year. When IL&FS defaulted, it triggered a panic reaction across the financial sector. It was not just IL&FS that was operating with a maturity mismatch risk but a whole host of NBFCs and HFCs that were operating with an unfavourable asset liability situation. What exactly do we mean by an asset liability mismatch? It refers to the risk of borrowing short term and lending long term. Most of the NBFCs and HFCs were doing that and IL&FS was the most flagrant example of using short term CPs and NCDs to fund long term infrastructure projects. As long as liquidity was abundant and fresh funds were coming in, this appeared to be a simple game. Borrow at low costs at the short end and lend for higher yield in the long end. The entire edifice crumbled when IL&FS default forced many mutual funds to take a write off. The trustees then asked all these funds to provide MTM losses on all their NBFC debt holdings. Now a little bit on the MF story!

How did MFs end up with a baggage of private bonds?

That is an interesting question and has a lot to do with the sharp inflows into equity and debt funds in the last few years. Obviously, there was not enough paper available in the market to absorb so much of inflows. Mutual funds, under pressure to enhance debt fund yields, began to look at alternate asset classes. That is when the NCDs and CPs issued by NBFCs came as a saving grace. They offered much higher yields than G-Secs and high rated paper. Mutual funds then went a step further and started promoter funding through this route. Promoters could transfer their shareholding to a private limited company and the said company will issue bonds to the mutual funds. These bonds were covered twice by the value of the shares pledged and so it did look like a fool proof scenario. The problems started when the rates were hiked in June and August and equity markets also crashed on the back of higher oil prices and weak rupee. That is when the entire cosy cycle broke down.

mf In the wake of recent downgrade of debt MFs, is it safe to invest in them?

Debt funds are selling; what to do?

Debt funds have been selling and selling bonds in a big way. In fact, most NBFCs and HFCs are confessing in private conversations that funding lines from mutual funds have all but vanished. In the last one year, overall Mutual Fund AUMs went up marginally by about 5% to Rs.24.5 trillion. However, debt funds saw net outflows to the tune of nearly Rs.1.60 trillion. This was largely due to domestic debt funds selling out on their corporate bond holdings in a big way. Here is what investors must do.

  • Firstly, stick to your asset allocation as per your financial plan. Debt still has an important role in your portfolio to render stability and regular income. That does not change.
  • Be wary of investing in credit opportunities funds as they still have a lot of pain of corporate bonds hidden in them. Rather stick to more of high quality income funds where you’re principal is much safer.
  • If you are a value digger, there are a lot of NBFC and HFC bonds that are available in the secondary market at a steep discount. When fundamentals have not changed, this is the time for some value buying in bonds. But, you must do it very carefully only!

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