Last Updated on December 8, 2023 at 9:00 pm
Last weekend, rating agency ICRA downgraded bonds of Infrastructure Leasing and Financial Services (IL&FS) . The long-term bond ratings went from AA(+) to BB. That is a huge downgrade! We need to stop and count this! AA(+) –> AA –> AA(-) –> A(+) –> A –> A(-) –> BBB(+) –> BBB –> BBB(-) —> BB(+) —> BB. That is a 10- notch downgrade!!
The short-term bond ratings went from A1+ to A4. So that is from A1(+) –> A1 —> A1(-) —> A2(+) —> A2 —> A2(-) —> A3(+) —> A3 —> A3(-) —>A4(+) —> A4. Again 10 notches. Source ETWealth and ICRA rating scale. In all fairness this is shocking. It is almost as if the rating agencies dozed off, suddenly woke up and realized that the bonds are not few notches below top grade, they are few notches above junk.
In this day and age, I find it incredulous that there is not enough information available to downgrade more gradually. This would have given responsible fund managers enough time to exit. I am not trying to imply that fund managers only buy using these ratings. However way they buy, the market price of these bonds will sway by these ratings and once a bond is downgraded, its price will fall as it becomes less valuable. So holders can only exit with a loss. You can read more about how this process works here:
1: Understanding Credit Rating Risk in Debt Mutual Funds
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2: Debt Mutual Funds: Credit Risk and Interest Rate Risk Can Co-exist!
3: Debt Mutual Funds: NAV Recovery after Credit Rating Downgrade
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I have mentioned several times that a debt fund holding only AAA bonds is not safe as the NAV will fall if AAA —> AA. Now with IL&FS episode, we must change that to AAA —> Anything! I won’t blame the debt fund managers for this. How will you feel if the five-star rate mutual fund drops to 1-star the month after you started a SIP in it (because it was 5-star)? It has happened in the past!
First of all, I think this downgrade is not a debacle, as thanks to past downgrades and SEBI ruling that exposure to a single security should not exceed 10% most of the schemes holding IL&FS did not have much exposure. If you were holding one of the funds that had above 5% exposure, don’t panic:
Here are your options:
1: If you don’t need the money, for now, leave it there. The NAV will gradually increase. If IL&FS pays back, then the NAV will rise up as fast as it went down and normalize. If the AMC sells the junk bond then the loss will be permanent. If the fund is a liquid or ultra short-term fund, recovery will take anywhere between weeks to months and longer for other types of funds. Returns will, however, fall significantly.
In the case of closed-ended funds (FMPs), there will be a full recovery if IL&FS honours payment. In the case of open-ended funds, even in the case of full payment, time would be lost and this is money and hence returns will be lower.
2: Book your loss and exit. You can use this short term or long term capital gain loss for offsetting and carry it forward for eight years. There is always a silver lining.
Second of all, if you feel happy that your debt fund did not hold IL&FS then, trust me, sooner or latter downgrades will affect all debt funds. There is no debt fund without risk. If you want to beat fixed deposit returns, then you must face losses. Otherwise, if you worried about risk in debt mutual funds? Park your money in overnight mutual funds
Here the risk is the lowest (but non-zero), but the returns will not be high. You cannot eat your cake and hold it too! And please don’t assume liquid funds holding gilt or sovereign bonds are safe. In July 2013 due to a weak rupee, RBI increase rates by a huge amount overnight resulting in a fall in all liquid funds. Weak rupee – sounds familiar?
Speaking of degrades, my Handpicked Mutual Funds (September 2018 PlumbLine) is filled with debt mutual funds and sooner or later, readers are going to complain about such bond degrades in them. If you invest without understanding disclaimers and risks, complaining will not help other than establish you to the world as an immature investor.
Third of all, I think many of us should change our attitude towards debt mutual funds. We must learn to stomach risk and face such NAV falls or stick to FDs and RDs. I have mentioned several times before, do not chase returns in debt funds, do not go after star ratings (as they chase returns). Credit risk is not a risk that fund ratings can capture as it is not present on a daily basis (like interest rate risk).
So you or the star rating portals will not recognise this risk until it hits and now many of the funds that held a lot of IL&FS bonds degrade from five/four/three stars to one star. After a few months, if they hold risky bonds and give good returns, they will back to five stars again and everyone will forget about this episode. See: Mutual Fund Star Ratings are Flawed, but Investors are to blame for taking them at face value
We must take a balanced view and be ready to face such risks. Debt mutual funds are fantastic and unique products and we should embrace after understanding risks and choose the right fund for the right occasion. They are not a replacement for fixed deposits.
The problem is (as in life) expectations. We see some past returns, we understand the tax benefit and assume debt mutual funds will beat fixed deposits. In fact, a large part of this belief stems from salespeople (as always). Debt funds can beat fixed deposits returns, but not always. Once we understand this, life will be easier.
Another problem is that unlike an equity mutual fund, a debt mutual fund needs to be watched over – as in look at monthly factsheets. In spite of SEBI recategorization, fund managers have considerable latitude wrt where they can invest. Even if we do keep an eye, such sudden downgrades and falls cannot be handled.
I strongly believe that investors must take on some amount of credit risk in their fixed income portfolio. The best way to do this is via debt mutual funds.
If you exit in panic, please recognise that no mutual fund is safe. Just that all those “sahi ads” do not tell you those. If you do not find out for yourself before you invest you will learn it the hard way.
The Indian bond market is pretty young and shallow. We have an EPF/PPF/FD mindset and there will not be many takers for degraded bonds (but enough takes before the degrade!). This has to change. I think the best way to deepen the bond market and also fund industry is to replace ELSS with credit risk tax saving fund with a lock-in. If you want anything to work, either offer it free or tax-free or tax saving!
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