Investors in debt funds are often prey to a common misconception. Many believe that, like bank deposits, investments in debt funds too cannot incur capital loss. But growing instances of sharp falls in the NAVs (net asset values) of debt funds, following credit rating downgrades, are proof enough to dispel such a notion.
There have been two instances of debt fund investors taking a hit, owing to credit rating downgrades of the debt instruments held by debt mutual funds. The latest victim is Taurus Mutual Fund.
The net asset values (NAVs) of four of its debt schemes posted a huge loss of 7-12 per cent in a single day (on February 22, 2017) after India Ratings and Research (Ind-Ra) downgraded ratings on Ballarpur Industries Limited (BILT). Taurus Dynamic Income Fund, Taurus Ultra Short-Term Bond - Super Institution plan, Taurus Short Term Income Fund and Taurus Liquid Fund - Super Institution plan, all saw their NAVs fall 11.8, 11.8, 11.1 and 7.2 per cent respectively on the day of the downgrade.
Why the loss
Just as the NAV (net asset value) of your equity funds can fall along with the underlying stock prices, so can the value of your debt fund with underlying bond prices. Interest rate movement is one factor that can impact bond prices.
Also, bond prices reflect the ability of the company to service its interest or principal and, hence, rise or fall based on the firm’s financial performance. 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, rating agencies can downgrade the rating on these bonds owing to several reasons. This can also mark down the value of the fund’s NAV. This is what triggered the sharp fall in the Taurus funds’ NAV.
As mandated by the SEBI/AMFI, while calculating NAVs, mutual funds follow a valuation matrix (a uniform pricing standard for the mutual fund industry) as prescribed by the rating agencies for the valuation of illiquid corporate debt papers. The valuation matrix considers the various risk factors, such as credit risk, interest risk and liquidity risk to mark-to-market illiquid corporate debt papers. Any rating downgrade leads to lowering of valuations of the papers.
The downgrade
The day before the fall in NAV, the rating agency Ind-Ra downgraded Ballarpur Industries Limited’s (BILT) Long-Term Issuer rating to ‘IND D from ‘IND BBB-‘. The agency also downgraded the company’s short term issuer rating (commercial papers) to ‘IND A4’ from ‘IND A3’.
The downgrade, according to the rating agency, reflects delays in debt servicing by the company. BILT, it says, continues to face delays in the necessary deleveraging, as efforts to monetise its assets have not fructified within planned timelines.
Till December 29, 2016, commercial paper issued by Ballarpur Industries enjoyed ‘IND A1+’ rating, the notch signifying the highest credit quality among short-term debt instruments. On December 30, 2016, the rating agency downgraded the credit quality to ‘IND A3/RWN’, which was further downgraded to ‘IND A4/RWN’ on February 21, 2017.
According to the latest portfolio data (as of January 31, 2017), the total investment held in the commercial paper issued by the Ballarpur Industries by the four Taurus schemes stood at ₹106.8 crore. The papers were among the top holdings in the three schemes –Taurus Short-Term Income Fund (11.96 per cent), Taurus Ultra Short Term Bond - Super Inst (11.94 per cent) and Taurus Dynamic Income Fund (11.84 per cent). Taurus Liquid Fund holdings in the paper were 4.3 per cent of its assets.
Not the first time
This is the third time, in two years, that rating downgrades have impacted the NAV of debt funds. During mid-2015, two debt schemes from JP Morgan Mutual Fund took a hit when Amtek Auto bonds were downgraded by rating agencies. The NAVs of JP Morgan Short Term Income Fund and JP Morgan India Treasury Fund fell 3.4 and 1.7 per cent respectively on the day of downgrade.
Similarly, in February 2016, when Crisil had downgraded Jindal Steel and Power Ltd’s (JSPL) long-term rating from BBB+ to BB+, the NAV of ICICI Prudential Regular Savings Fund fell by 0.54 per cent while Franklin India Short Term Income Plan and Franklin India Income Opportunities Fund fell 1.63 and 1.57 per cent respectively, in a single day.
Investors beware
A few funds invest in lower-rated debt instruments to maximise their returns. But even top funds have fallen prey to wrong credit calls and sudden downgrades by rating agencies. Investors can, however, minimise their risk by avoiding investing in funds that have a higher proportion of low-rated bonds.
Also, run a check on the concentration of the fund’s portfolio. SEBI, last year, pruned the exposure limit a debt fund can have to one issuer, to 10 per cent of the NAV. This can be extended to 12 per cent of the NAV with the prior approval of the Board of Trustees and the Board of the Asset Management Company. Funds holding a high proportion of assets in a single company can be avoided.