Imagine that you are a risk-averse investor and wanted to “park” some money for a few days, and desired to earn a bit more than a savings bank account, an overnight mutual fund is a reasonable choice. If you wanted to extend the investment duration to a few months, a liquid mutual fund is not bad a choice either. Suppose you wanted to invest for a few years, then the usual choice is an ultra-short-term fund. In 2019, it is not possible to take these choices for granted! In fact, it almost appears as if it has become impossible to choose debt mutual funds for the short term!
Announcement : The kindle version of my first book, You Can Be Rich Too is only Rs. 65 at Amazon!! You do not need a Kindle to read it! You can do on Amazon Cloud via your laptop or via the Kindle app for Android or IOS.
My second book, GameChanger is also only Rs. 99!
Risk averse only means that the investor expects the NAV to fluctuate daily but not result in a negative quarterly return (in case of liquid funds) or annual returns with ultra short-term funds. The IL & FS bond degrade in Sep 2018 taught us many lessons: The credit rating of a bond could fall by 9-10 places almost overnight! The NAV of a liquid fund (Principal Cash Management Fund), a money market fund (Tata Money Market Fund), an ultra short-term fund (Motilal Oswal) and even an arbitrage fund (Principal) could drop like a brick because of a rating downgrade As I write this, new came in of an IL & FS SPV bonds degrade affecting funds of UTI and HDFC among others.
Are the AMCs to blame? Yes, they are. Their greed to shift the large AUM “rotting in bank deposits” to debt mutual funds led to (1) giving investors the impression that debt mutual funds are an “alternative” to bank deposits and can fetch higher returns and (2) to achieve this and beat peers, take on higher credit risk.
Are star rating agencies to blame? Yes, they are. They refuse to point out that their star ratings cannot factor in credit risk.
Are investors to blame? Yes they are. For taking the above parties seriously. See: Mutual Fund Star Ratings are Flawed, but Investors are to blame for taking them at face value
What is the actual problem?
Investors seeking a liquid fund or overnight fund want extra returns compared to a savings bank account but also want no credit risk. This is a reasonable expectation. they are okay with the NAV going up or down every other day by 0.01% and not a 10% overnight fall!
This means, they are looking for a fund with a low interest rate risk and near-zero credit rating risk. This is becoming harder and harder by the day.
Overnight mutual funds fit the bill, but one cannot guarantee that the credit risk is zero. The only advantage here is, even if there is a default, the recovery (for small exposures) will be the quickest. If you settle for these, then returns will also be lower.
There was a time when liquid funds was the automatic choice (overnight funds were then also called liquid funds). However, the IL & FS fiasco has taught us that if the company fails as a whole then all its bonds regardless of duration will fall in rating including those in a liquid fund.
There is still a simple, but crude way to to choose a liquid fund in 2019 by minimizing credit risk.
Move away from liquid and overnight funds, the next in terms of duration are the money market funds. Generally, funds here tend to hold A1+ bonds, the highest rating for short-term bonds by CARE. A1 stands for
Instruments with this rating are considered to have very strong degree of safety regarding timely payment of financial obligations. Such instruments carry lowest credit risk.
So A1+ is a bit higher than A1. However, this does not exactly mean “safe” IL& FS short term bonds went from A1(+) –> A1 —> A1(-) —> A2(+) —> A2 —> A2(-) —> A3(+) —> A3 —> A3(-) —>A4(+) —> A4. That is 10 notches overnight on the CARE scale!
The problem is not A1+ dropping to A1 or A1(-) to A2. That will affect the NAV but not cause an Earthquake. The problem is these huge downgrades. Naturally, they are outliers, but it is a real risk and investors will have to account for it.
So we now have evidence of a credit rating downgrade in pretty much every category! Liquid funds, money market funds, ultra-short term, arbitrage, dynamic bond, corporate bond, medium to short duration funds, credit risk funds (which is the only place where it is expected) and even banking and PSU funds.
So the actual problem is, no category is safe! Because practically no debt fund* says in their scheme document (as far as I have seen) that “we will not invest in X or Y type of bonds”. The scheme document is more a license for them to invest anywhere under the sun!
* Quantum Liquid is an exception. It:
does not take exposure in private sector corporations and invest only in government securities, treasury bills and highest quality instruments issued by public sector undertakings (PSU) Source: Quantum Newsletter
What is the solution?
We have gilt funds where there is no credit risk, but all of them hold medium to long term bonds making the daily NAV quite volatile. There is no open ended or closed ended or interval fund that invests only in short term gilt funds. I am tired of saying this! See Open Letter to AMCs: Why are you not pushing Risk-free Debt funds enough? See: Death of a good mutual fund: DSP BlackRock Treasury Bill Fund
Credit rating risk is not the problem. The problem is credit rating risk is not segregated! Except for overnight funds, practically all mutual funds take on credit risk. It is one thing for a A1+ bond to drop 10 grades, but if a fund holds A and AA rating bonds, The fall by a single grade can affect NAV noticeably if the exposure is not small.
So the problem, I cannot find a liquid fund or any other type of debt or hybrid fund that says, “we will only invest AAA or A1+ rated bonds”
Credit risk risk is not a problem because one can take a chance with those for longer investment durations. Even if I hate credit risk, long term gilts will work for long-term goals (5Y +). For short investment durations, I must be able to find a fund that will only invest high-quality bonds. From what I see, this has become pretty much impossible.
Why? Because if AMCs restrict themselves like that, the star ratings will fall (as they are flawed). Remember, a high quality bond will only shell out low interest payout. So the returns will be low and investors will avoid these. Distributors cannot push these.
So the answer to the tittular question is, yes, it become impossible to choose debt mutual funds for the short term … without worrying about credit rating risk
The solution to this simple. How many debt funds should fall and how many investor should suffer for SEBI to introduce short-term gilt category and mandate credit rating limits for overnight, liquid and money market instruments? Easy to say that the investor should be aware of risks, but the regulator, instead of trying to popularize mutual funds, should first make them simpler products!
So what should investors do?
If you are scared of credit risk, avoid all debt mutual funds except overnight and liquid funds that you trust (preferably large AUM) for short term goals. For long term goals, gilt funds will work, but some portfolio management is necessary. We will discuss that in a separate post.
Check out the latest videos from freefincal @ YouTube
Subscribe and join the freefincal Youtube community!
Connect with us on social media
- Twitter @freefincal
- Subscribe to our Youtube Videos
- Posts feed via: Feedburner
- We are also on Google PlusandPinterest
Do check out my books
Get it now. It is also available in Kindle format.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You WantMy second book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at low cost! Get it or gift it to a youngearner
The ultimate guide to travel by Pranav SuryaThis is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for ₹199 (instant download)
Free Apps for your Android PhoneAll calculators from our book, “You can be Rich Too” are now available on Google Play!
Install Financial Freedom App! (Google Play Store)
Install Freefincal Retirement Planner App! (Google Play Store)
Find out if you have enough to say "FU" to your employer (Google Play Store)