The multiple defaults by IL&FS have shaken the debt mutual fund investor to the core. With liquid funds, money market and credit risk funds finding their IL&FS exposure as a veritable Achilles’ heel, the average debt MF investor finds himself questioning if debt MFs are as safe as they are made out to be.
In some cases, there have been losses in debt funds. Many AMCs had exposure to IL&FS debt securities and when the credit rating agencies started downgrading those securities, all hell broke loose. But not everybody was found struggling. Some fund-houses escaped unscathed despite exposures. But, just a handful of fund-houses can claim that they have largely avoided multiple instances of issues with debt fund investments over the last 8-10 years.
In a note to investors, HDFC Mutual Fund has reasoned that its focus on high credit quality largely avoided above credit stress cases. Let’s find out more.
The recent stress in the NBFC sector triggered by IL&FS default is out in the open. A high proportion of debt funding long-term assets & equity investments, asset liability mismatch, and increased dependence on refinancing pushed IL&FS towards a potential insolvency. At the end of FY18, it has gross borrowings of Rs 91,000 crore. Of this, Rs 60,000-65,000 crore is in project SPVs and serviced largely through project flows. Total debt at risk, thus, is near Rs 30,000 crore, i.e. 0.3% of the total bank credit. Yet, the NBFC market and debt market panicked.
There have been some casualties too. Tata Money Market Fund had to lose nearly 6% NAV in one day after writing down its IL&FS exposure. BOI AXA Credit Risk Fund also marked down its complete IL&FS exposure to zero on October 5. Principal Mutual Fund stopped fresh inflows into its some of its debt funds. As IL&FS fails to repay debt, DSP Credit Risk Fund was hit too.
You can read our full coverage of the IL&FS impact on various mutual funds here – https://www.rupeeiq.com/content/tag/ilfs/
So, as NBFC sector debt faced uncomfortable questions, many fund-houses have realised the risks of investing in them. NBFC debt or any other debt is subject to good credit selection. Debt MF investors give money to managers to invest judiciously. So, any wrong credit selection can hit investors big time, almost like a bad equity investment.
HDFC MF fixed income approach
HDFC Mutual Fund, one of the two listed AMCs in India, has come out with its debt presentation. In a nutshell, it has talked about its debt investment approach in which it claims it has remained unscathed by the ongoing debt crisis.
So, what is HDFC MF’s secret sauce? Its investment philosophy for fixed income is focussed on credit quality. This means the AMC ranks credit quality as extremely important.
HDFC MF talks about its SLR philosophy. This is generally prioritised in that order – S comes first, then L and last is R.
S stands for Safety – Superior credit quality companies with a low probability of default. Great credit instruments from great companies never default. The default is an important thing. In debt or fixed income, you basically lend money as an investor through a debt fund. If the money is not repaid, its the biggest risk that can happen. In the equity investment side, stocks lose value too but how many stocks do lose 100% value? In debt, not repaying money means 100% loss.
L is for Liquidity – HDFC MF says its endeavour is to invest in securities with better liquidity. Liquid assets can easily be sold off or bought. Think of a buying a Rs 5-crore Ferrari and a Rs 5-lakh Maruti Swift. While Ferrari is a great car, Swift is bought and sold by everybody. If you wanted to sell a Ferrari, you would need a crorepati to come as the buyer. With a Swift, the potential pool of buyers is huge. This is applicable to debt instruments too. The focus on dealing in liquid instruments helped AMCs lower risk, and gave them the agility to move in & out of opportunities.
R is for Returns – Return goes hand in hand with Risk. You cannot get great returns without taking great risks. But all fund managers try to spot opportunities by using the risk-return framework. But not everybody does a great job. HDFC MF says that it aims for a better risk-reward ratio. Even in the best of credit environments, it has endeavoured not to take undue credit risk, even at cost of marginally lower Yield To Maturity (YTM).
HDFC MF has a credit risk assessment framework. These are broad guidelines to assess debt securities.
According to HDFC MF, it gives emphasis on 4 C’s of Credit.
Character of Management
Capacity to Pay
Collateral pledged to secure debt
Covenants of debt
The fund-house also has a practice of investment limit setting through a Credit Scoring Model which factors – Parentage, Financials, Rating & Outlook.
Plus, the fund-house has issuer level limits (% of scheme AUM) which are a function of credit score – better the score, higher the limits. Of course, all this is within the permitted regulatory limits.
The fund-house actively monitors and tracks cumulative absolute exposure limit across fund house for each issuer and business group. There is a list of approved issuers & their exposure limits are reviewed periodically.
There is no way of knowing if a certain fund-house will get sucked into the next financial crisis. Truthfully, nobody knows. But, it is important to understand the process of credit selection and credit investment. Investors will increasingly play a bigger role in the debt MF space. So, the onus is on you to understand and realise how popular and big fund-houses look at debt.
To read HDFC MF’s presentation, click here http://poweraxis.com/projects/emailer/hdfcmf/2018/october/pdf/HDFC-Credit-Risk-Debt-Fund-Oct18.pdf