Is your debt fund taking too much risk?

The exposure of short-term debt funds to A-rated paper has increased recently. Here’s how it can impact you

Debt funds have given very good returns in recent months. However, if you are planning to invest in them, take a closer look at the portfolio before opting for the best performing scheme. The higher returns mdebt funday be due to the fund manager taking more risk than you are comfortable with.

Some short-term debt funds have sharply increased their exposure to risky , lower rated bonds in recent months, while reducing the same to safer AAA-rated bonds. The category now has 6.46% of its assets in A-rated paper, the highest exposure to this grade of bonds in the past five years. At the same time, the exposure of the category to AAArated paper has declined from 98.68% five years ago to a low of 69.05% now. Some funds have 30-40% of their assets in A-rated bonds (see graphic).

The credit rating denotes the credit worthiness of the issuer of debt instruments–the lower the rating, the higher the risk of default by the issuer.

In the credit quality ladder, A-rated paper falls below AAAand AA-rated papers. Even though this doesn’t make them very risky , they are obviously not as safe as the AAAor AA-rated bonds. So the investors who had bought short-term debt funds as tax-efficient alternatives to fixed deposits may not be comfortable with the risk that these instruments carry .

The trend is visible in other categories as well, though to a lesser extent. The ultra short-term bond funds have 0.96% of their assets in A-rated bonds, while intermediate bond funds have 1.64%. Why have the funds adopted this strategy?

Clearly, the quest for higher yields has led fund managers to venture into these lower-rated bonds.

The prolonged high interest rate environment has deprived the debt market of opportunities to increase returns. Fund managers can either boost the returns by opting for long-term bonds (which are more sensitive to interest rate changes and, therefore, have the potential to give higher returns in case of a fall in interest rates) or increase the exposure to lower quality bonds that offer higher yields.

The yields of A-rated bonds are typically 2-3 percentage points higher than those of AAA-rated bonds.

Experts reckon that the increase in exposure to lower rated bonds was driven by circumstances.

“This is primarily because of the spike in interest rates in 2013, when the RBI was clearly not in a hurry to bring down the rates. Most fund managers preferred to play down the credit ladder rather than play the duration strategy,“ says Niranjan Risbood, Director of Fund Research, Morningstar India.

“The five-year spread on AAA-rated paper over gilt has narrowed significantly . In this situation, when the yield curve falls, fund managers have little choice but to opt for lower quality paper, which offers a higher spread,“ says Vidya Bala, Head, Research, FundsIndia.

However, this strategy has a flipside because the exposure to low quality paper enhances the risk profile of the fund. “If the issuer is unable to return the capital at the time of maturity, the funds will take a hit. The entire investment could be wiped out, eroding the NAV of the fund,“ cautions Risbood.

Besides, liquidity can be an issue with lower rated instruments. As these are not traded too much, a large-scale redemption may force the fund manager to sell them at significant discounts.

Meanwhile, the holding in AA-rated bonds has also increased, but experts are not worried. “Many of these are carefully chosen instruments issued by good companies, whose ability to service debt is no lesser than an AAA-rated company,“ says Bala.

The increased exposure to AA-rated paper is also a sign of confidence in the corporate recovery . Many companies have started deleveraging and the quality of the paper issued has actually gone up though they have not been re-rated. Even so, investors should ascertain the risk before taking a decision. Says Risbood: “Ensure the fund house has good credit assessment ability while opting for any scheme.“