Risks and returns

The recent bout of panic in debt markets over the IL&FS default and the NBFC liquidity crisis have exposed major fault-lines in the Indian bond market. But these imperfections haven’t stopped domestic mutual fund (MF) managers from looking beyond sovereign and AAA-rated corporate bonds to deploy their investors’ debt money. A BusinessLine analysis has showed that, in the past year, debt funds have been reducing their allocations to gilts and AAA-rated corporate bonds, only to step them up in bonds rated AA and below. Bonds enjoying ratings of BBB and above are categorised as investment grade and domestic debt schemes still invest over 98 per cent of their assets only in these bonds. But given the peculiarities of the Indian bond market, MFs’ rising exposure to non-sovereign bonds does flag some risks. After several episodes of multi-notch downgrades and defaults in ‘investment grade’ bonds in the last five years, the credibility of the rating agencies is wearing thin. Patchy market liquidity makes it quite difficult for funds owning lower rated bonds to sell them at short notice. Erratic trading also makes the daily valuation of such bonds a tricky affair.

There is nothing wrong with debt fund managers, like their equity counterparts, taking on more credit risk in their portfolios to bump up returns. In fact, institutional investors and corporate treasuries who have long dominated Indian debt MFs may actively encourage such risk-taking by chasing funds with higher yields. But the fund industry needs to recognise that the new individual investors in their debt schemes, who now make up 35 per cent of assets with ₹4 lakh crore parked with them, may not be equally comfortable with, or even aware of, this risk-return trade-off. Retail fixed income investors are ill-placed to evaluate MF portfolios to gauge the credit risks lurking there. It is therefore critical for the industry, at this juncture, to ensure that high-yield funds aren’t mis-sold to retail investors as tax-efficient bank deposit or pension substitutes. AMFI must also look to divert part of its coffers from the ‘Mutual fund sahi hai’ campaign to educating investors on the risk-reward equation in debt funds.

From a market development perspective, MFs’ rising participation in lower rated bonds is certainly good news, as other institutional bond buyers such as banks, insurers and pension funds tend to be both extremely passive and highly risk-averse. But if debt MFs are to navigate this tricky space without disappointing investors, it is essential that they get an adequate supply of paper and ready counter-parties for secondary market trades. SEBI’s new guidelines in November requiring large companies to source a fourth of their annual debt requirement from the market, should help address the supply issue to some extent. But other financial market regulators such as the RBI, IRDA and PFRDA also need to nudge their constituents to build in-house credit assessment capabilities and foray down the rating scale to really shake this market out of its slumber.

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