Debt funds raise exposure to lower-rated bonds

Investors have made tidy returns in debt funds over the past year, thanks to the sharp fall in interest rates. But a hunt for higher returns seems to have taken funds towards riskier instruments.

A look at the credit profile of debt funds shows that more money has flowed into high-yielding but low-rated corporate bonds over the past year. The total corpus, or assets under management (AUM), of AA and below-rated bonds, across all open-ended debt funds put together, has grown a whopping 58 per cent to ₹1.6 lakh crore. AUMs of safer AAA rated bonds grew a lower 28 per cent.

Bonds with AAA rating are considered to have the highest degree of safety, and carry the lowest credit risk.

While AAA rated bonds still form the chunk of the overall corpus, its share has fallen by 7 percentage points over the past year, to 56 per cent. The share of AA and below-rated bonds have inched up 2 percentage points to 16 per cent as of February 2017.

The data has been compiled from NAV India and ACE MF.

Of the many debt fund categories, it is the credit opportunity (CROP) funds that are being chased by investors and fund houses for better returns. CROP funds tend to capitalise on interest receipts, rather than gain from bond prices. In other words, they earn higher interest by investing in lower rated (non-AAA rated bonds).

The total AUM of CROP funds have grown 52 per cent Y-o-Y to around ₹1.26 lakh crore as of February 2017. The holding of AA and below-rated bonds within their portfolio has also grown at a similar rate, constituting about 61 per cent of their portfolio.

Ultra short-term and short-term funds too have seen a sharp increase in their AUM and holding of low-rated bonds.

Going by the growing instances of sharp fall in net asset values (NAVs) of debt funds — that are triggered by credit rating downgrades — holding lower-rated paper seems to signal a higher risk.

Over the past two years, there have been three instances of debt funds taking it on the chin, owing to credit rating downgrades of the debt instruments they hold. In mid-2015, two debt schemes from JP Morgan Mutual Fund took a hit of 2-3 per cent on a single day, when Amtek Auto bonds were downgraded by rating agencies. Similarly, in February 2016 when Crisil downgraded Jindal Steel and Power, the NAV of ICICI Prudential and Franklin schemes fell nearly 1-2 percentage points.

More recently, four of Taurus’ debt schemes posted a losses of a significant 7-12 per cent in a single day after India Ratings and Research downgraded ratings on Ballarpur Industries Limited.

If a company actually defaults on its interest or principal repayment, then the debt fund’s portfolio, to that extent, is written off. This will impact the NAV of the debt fund. But even if a bond does not default, downgrades by rating agencies can mark down the value of the fund’s NAV.

Franklin Templeton AMC, which is among the 15 biggest asset management companies, holds about 59 per cent of its debt AUM in lower rated bonds — AA and below. Birla, HDFC and Kotak, have allocated 16, 16 and 14 per cent respectively for such bonds. On the other hand, SBI, UTI and IDFC apportion a much lower 6-9 per cent.

This divergence is due to the broad mandate that each fund house follows. If fund houses, or specific schemes, have a mandate to chase high-yield corporate bonds, then the portfolio will show a high proportion of low-rated bonds.

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