Investing in debt funds, but afraid of risks?

While debt funds have emerged as the flavour of the season, not all investors understand debt funds.
So the best they can do is put trust in the fund manager and the fund house, experts tell Tinesh Bhasin.

It's isn't easy being a debt fund manager when credit ratings of companies are being downgraded on a regular basis.

The problem is dual, say fund managers -- investors seek high returns from debt funds, but are unwilling to take risk.

"If I take riskier papers to shore up returns, the investor should realise there are chances that things may go wrong," says a debt fund manager who did not wish to be named.

However, given the number of downgrades, fund managers have been forced to seek collateral or adding covenants.

"In the current credit environment, where we are witnessing bad loans, credit downgrades and defaults, taking collateral gives additional comfort to the fund manager," says Dwijendra Srivastava, CIO -- fixed income, Sundaram Mutual Fund.

Fund houses that invested in Essel Mining and Industries papers, for example, had put conditions before lending.

Though it was an Aditya Birla Group Company, one of the covenants of ICICI Prudential Mutual Fund was payment of higher interest rate if the paper is downgraded.

Collateral don't reduce risk

The collateral that fund houses take in such deals vary.

It can be a stake in the company through pledge shares, promoter guarantee, shares of a listed company, cash flow generating assets, and so on.

If a company defaults, only a few among these can be easily liquidated.

"It's difficult to get the money back despite all the collateral and covenants if an entity defaults as the laws in the country are still not strong enough to deal with such situations," says a debt fund manager.

In credit opportunities fund, Baroda Pioneer Credit Opportunities Fund has the highest returns of 11.98 per cent.

Around 56 per cent of the portfolio is invested in AA-rated securities and 11 per cent in AAA as of July 31, according to Value Research.

Birla Sun Life Corporate Bond Fund, which has the second highest returns at 11.52 per cent, has 26 per cent of the portfolio in AA-rated papers and 24 per cent in papers rated A or below. But it also has 40 per cent portfolio in the highest rated (AAA) securities.

Difficult to know the structure

Explains A Balasubramanian, CEO, Birla Sun Life Mutual Fund: If a company has good cash flows and the nature of business gives comfort to a fund manager, he would opt for financial collateral and covenants such as shares of the company, cash flow generating asset, etc.

If it's a holding company of a promoter with a pedigree, then he can choose to take a stake through pledge shares, can put restrictions on borrowings, ask for promoter guarantee and so on.

What investors can do

An investor, therefore, needs to be cautious when investing in a fund that might have credit risk.

"Look at the fact sheet of the mutual fund. It gives a credit rating break-up of the portfolio. Invest if you draw comfort from it," says Kaustubh Belapurkar, director of fund research at Morningstar Investment Adviser India.

Even if an investor is willing to take a risk that these funds carry, it's not possible for him to know the terms and conditions of a deal and its structure.

Such deals can be complex with multiple conditions, guarantees and collaterals. Even financial advisors cannot help in such a case.

"We endeavour to identify credit worthy companies before market discovers it. Early access to companies with a strong financials or promoter backing, though lower rated, can help to get better returns. We don't wait for rating agencies to assign ratings and then act," says Amit Tripathi, CIO -- fixed income investments, Reliance Mutual Fund.

Investors, therefore, need to put their trust in the fund manager and the fund house.

"Finding the track record of a fund manager is far easier than analysing the papers in the portfolio. Also, opt for a fund house with a proven track record," says Balasubramanian.

Photograph: Kind courtesy Mark Ou/Creative Commons