In the current context, stick to portfolios that are well-diversified

Theoretically, there are multiple risks in debt funds; these may add up to, say, 10 in number. Of these, the important and relevant ones are volatility,  and credit/default risks. In long-maturity debt funds, for example, G-Sec or long duration schemes, volatility risks are higher as market movements have a higher impact on fund returns.

Default risks are lower in long maturity funds as the portfolio’s credit quality is better. In shorter maturity funds, for example, short duration schemes, the volatility risk is relatively lower as the impact of market volatility on fund returns is that much lower. The default risk is subjective; BBB-rated exposures may sail through smoothly, i.e., honour principal and interest payment obligations. However, as we have seen over the last one year, even an AAA-rated exposure may default.

Gauging the impact of volatility

We will take the two most severe market incidents for illustration to gauge the impact of volatility and default on returns from shorter maturity debt funds. The most severe market volatility incident happened in July 2013, when the RBI raised interest rates and squeezed the system’s liquidity. The impact was obviously severe on longer maturity funds; we are not discussing that here because, in the current context, longer maturity funds are not recommended.

The RBI has an easy monetary policy approach and may cut rates further, but we are in the last leg of policy rate easing; hence, there is nothing much to gain, on a risk-reward basis, from long maturity funds. Short maturity funds will be impacted less, in case interest rates/traded yields of bonds in the market move up (i.e. bond prices come down), and will gain to a limited extent if bond yields come down (i.e. bond prices move up). The other major risk is default risk; the most severe period of credit defaults in the market is the current one that we are witnessing over the last one year or so.

Taking a basket of short-term funds (now called short duration funds as per SEBI’s classification) with July 15, 2013 as the starting date, i.e., the date just before the severe RBI measures, the one-month average return was a negative 16.6 per cent annualized. However, the three-month average return from the basket, starting from July 15, 2013, was a positive 5.2 per cent. Similarly, the six-month average return was a positive 6.5 per cent and for the one-year period, it was a positive 7.9 per cent. How did the funds recoup the loss incurred in the one-month period of severe market volatility within a few subsequent months?

For one, the accrual in debt funds is always there – the interest due on the portfolio holdings that are added to the NAV on a daily basis. But it takes time for accrual to make up for extreme market movements. Any improvement in the market subsequently, i.e., yields on securities in the market coming down, adds to the returns. Similarly, on a basket of Credit Risk Funds, the one-month return was a negative 15.4 per cent; for the three-month period it was a positive 5.8 per cent, and for the one-year timeframe, the return was a positive 8.7 per cent.

Now coming to the impact of default risk on the portfolio, the one-year (from September 6, 2018 to September 6, 2019) average return from a basket of short duration funds  was 5.36 per cent. This includes the highest return of 10.65 per cent from the best performing fund with no default in the portfolio and the worst performing scheme with negative 13.6 per cent return due to multiple defaults. The impact on credit risk funds is more damaging. The one-year (September 6, 2018 to September 6, 2019) average return from a basket of credit risk funds from was 0.88 per cent. This includes the highest return of 8.89 per cent from the best performing fund with no default in the portfolio and the scheme with the worst return of -47.9 per cent with multiple defaults.

What we observe from the data discussed above is that in the volatile market phase of 2013, shorter maturity funds were able to recover within a year. Long duration funds took more time, as the damage was bigger. In the current phase of market defaults, shorter maturity funds have not been able to recover to that extent, as defaults have been a recurring phenomenon. Regular daily accrual and favourable market yield movements are there, but in spite of that the one-year returns are subdued. This has been the extreme phase of defaults ever in the industry. Once a default happens, and exposure to a single security can be up to 10 per cent as per SEBI rules, mark-down is done according to valuation given by rating agencies—CRISIL and ICRA.

Recovery in non-side-pocketed portfolios can happen only if the company turns the corner, which may be unlikely, or the company is liquidated by the NCLT/other court of law and there is some solace; but that is a long-drawn process and chances of recovery are on the lower side.

In the current context, stick to portfolios that are well-diversified, i.e., credit risks are spread out, credit rating of the exposures are higher and the issuers or the securities belong to the safer categories such as PSUs and Banks. The alpha of debt funds comes from either of the two risks – duration or credit – and funds in both the categories have their niche.

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