By choosing debt funds with a different mix of bonds, investors can increase the chances of some bonds performing well even at times others do not
It is a well-known fact that equity markets are risky and investors with high risk appetite invest in such markets for potentially higher returns. However, liquid funds, which are high liquidity open-ended income schemes that invest in debt and money market instruments such as Government securities, treasury bills and call money among others, have always been a safe haven for risk averse investors who consider these investment avenues as an alternative to bank savings account to beat inflation. These instruments have a maximum maturity period of 91 days and are considered safe because they mitigate interest rate volatility risk. And to add cherry on top, the net asset value (NAV) is calculated for 365 days as compared to other debt funds where the NAV is calculated only for business days. Overall, liquid mutual funds can win hands down from bank savings, especially fixed deposits, not only in terms of returns but also in liquidity and lower tax outgo.
However, for the last one month, investors were in for shock with some liquid mutual funds falling anywhere from one to five percent on a daily basis. Generally, in stock markets, one has to look at long-term returns, but by nature, liquid funds are short-term in nature and the negative returns would have proved a nightmare for investors with an investment horizon of one month or so. The main reason for this downward spiral has been the quick and successive downgrading of commercial paper issued by IL&FS by ICRA from “ICRA A1+” to “ICRA A4” on September 8 followed by another demotion from “A4” to “D” on September 17, due to overall deterioration of its financial health. In addition, corporate bonds and long-term loans of IL&FS were downgraded from AA+ to BB. Similar downgrades were also witnessed across the debentures and/or commercial paper of other group companies like IL&FS Financial Services, IL&FS Tamil Nadu Power Company, IL&FS Energy Development Company, IL&FS Transportation Networks and IL&FS Education & Technology Services.
As many as 32 liquid funds from 12 AMCs had exposure of IL&FS and its group companies to the tune of Rs 2,283 crores as on August 31, 2018 and any maturities that are due over the next few months would make an interesting observation. This was a wake up call for all investors who considered investing in debt or liquid mutual funds safe. By all means, it is a safer option for investors who have less tolerance to risk, but whether the investment is in equity or debt, quality of the underlying asset is of utmost importance and one cannot hope to achieve sustained growth in the value of investment if the quality of the underlying asset, be it stocks or debt, is poor. For guidance, investors can look towards credit rating agencies, which are regulated by the Securities and Exchange Board of India (SEBI) in India and provide a benchmark to investors to help them take correct investment decisions by analysing companies considering several factors like, financial statements, lending and borrowing history, level and type of debt, ability to repay the debt and so on, with poor credit rating indicating that the company is at a high risk of default. The famous credit rating agencies in India are CRISIL, ICRA, CARE, Brickwork Ratings, India Rating and Research and SMERA for small and medium enterprises. According to the SEBI, long-term debt instruments can have the highest rating of AAA and lowest of D, where instruments are already in default or are expected to be in default.
Similarly, the ratings for short-term debt instruments can range from A1 to D. What is surprising, however, is the quick and sharp downgrade of ratings of IL&FS from A1+ to D. Were the credit rating agencies caught unaware of the financial health of IL&FS or are there more skeletons in the cupboard? How will the investors protect themselves if the credit rating agencies fail to do their job efficiently? In this case, all liquid funds that have high exposure to IL&FS and its group companies face default risk or credit risk, the probability that it will default on the required payments on the debt obligations. The other risks that investors in debt or liquid funds should be aware of are interest rate risk, a risk that an increase in the general level of interest rates will cause the market value of existing investments to fall; inflation risk, a risk that an investor faces that the return one earns on the investment doesn’t keep pace with inflation, and market risk, a risk that the entire bond market declines. If this happens, the price of the debt or liquid mutual fund will fall regardless of the type and quality of debt instruments it is invested in.
So, how can investors protect themselves from the inherent risks? One way is to follow the strategy of laddering. Buy different liquid mutual funds where the underlying instruments mature at different times, which will reduce the overall maturity risk and also frees up capital at different times, which can either be used as income or can be further reinvested. The second strategy is diversification. By choosing debt funds with different mix of bonds, investors can increase the possibility of some bonds performing well at times when others are underperforming. These strategies can help investors tide over ups and downs.
(The writer is Assistant Professor, Amity University)
