Understanding Credit Rating Risk in Debt Mutual Funds

Many debt mutual funds invest in corporate bonds which carry credit risk. It is important for investors to understand how this can affect debt mutual fund returns.

Yesterday, rating agencies, CRISIL, ICRA and CARE downgraded short-term and long-term ratings on Jindal Power and Steel bonds.

As a result, the NAV of debt funds which held Jindal bonds fell. Have a look at this summary by Manoj Nagpal.

This fall is not of the same magnitude as the fall in JP Morgan funds (see below). This rating downgrade is also different in nature. I think investors can continue to hold Franklin Templeton funds. Unlike Amtek Auto, I think Jindal Steel should be able to pay back the principal to FT when the bond matures. The NAV fall was only a  market-linked fall. FMP returns will be lower.

This is the second time in six months we see such a fall in debt funds. In Aug 2015, JP Morgan AMC was in the news for the wrong reasons.  The NAV of two of its debt mutual funds, JP Morgan Short Term Income Fund and JP Morgan India Treasury Fund fell by -3.38% and - 1.73% on Aug. 27.  The reason: both funds held debentures (bond) of Amtek Auto which was downgraded from AA- to C.

A look at how credit rating changes affect debt mutual funds.

Amtek Auto-JP Morgan

Categories of debt mutual funds can appear difficult to understand than that of equity mutual funds. There is a simple way for investors to understand the risks associated with different debt mutual fund categories - the modified duration.

As pointed out in previous posts, the modified duration is measured in years and gives us two pieces of information:

  1. For 1% change in interest rates, what would be the expected increase or decrease in fund NAV. A modified duration of 2 years implies, a possible NAV change of 2% for 1% change in interest rate. So longer the modified duration, higher the interest rate sensitivity.
  2. For a given yield to maturity, how long would the fund take to recover, if there is a loss due to increase in interest rates.

The key to understanding credit rating risk is to recognise that credit risk does not refer to risk of default alone (bond issuer does not pay interest). Since debt mutual funds are  marked to market, any change in credit rating will affect the price of the bond and therefore, the NAV of the fund.

There are two types of interest rate changes that affect the NAV:
1) RBI action on short-term interest rates which will impact long-term rate of GOI bonds and corporate bonds as well.

2) Change in credit rating of a corporate bond.

Many investors are under the misconception that corporate bond opportunity funds  are immune to RBI action. This is incorrect. Corporate bonds carry a risk premium (higher interest rate) with respect to GOI bonds which will change when the GOI bond rates change.

Due to this risk premium, Corporate bonds must be graded as per their perceived ability to repay the principal. This is referred to as a credit rating.

Higher the credit rating, higher the faith in the company and lower the risk of default.

Now if the credit ratings go up for a bond, the interest rate of the bond in the market will decrease. Therefore, the value of the bonds the fund currently held by the fund will be worth more than those in the market.  Thus, the NAV of the fund will sharply increase.

Conversely, if the credit ratings go down for a bond (like it did for Amtek Auto), the interest rate of the bond in the market will increase. Therefore the value of the bonds held by the fund will be worth less, and the NAV will drop sharply.

In either case, as long the firm repays the principal to the fund, the NAV over time will gradually get back to the normal linear movement.

If you wish to calculate how long it would take for the recovery (in case of a credit rating downgrade), you can consult this post: Understanding Interest Rate Risk in Debt Mutual Funds

However, if the firm defaults then the loss is permanent (thanks to Mahesh Mirpuri for clarifying this).

Therefore, due to fear of default a debt fund, in this case the above-mentioned funds, may face redemption pressure.

If you wish to choose debt funds that invest in corporate bonds, I suggest you choose funds with low modified duration (much less than one year). So even if there is a downgrade in credit rating, the loss (assuming no default) can be recouped in a couple of months.

You can minimise such risks by using the so-called Banking and PSU debt mutual funds. They invest in bond issued by PSUs and banks only.

To lower credit risk and interest risk, I would shun every other debt fund category except ultra short-term funds and liquid funds.  See why here: Investing in debt mutual funds: slow and steady wins the race!

Another read on the subject: How to Select Debt Mutual Funds Suitable For Your Financial Goals?

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17 thoughts on “Understanding Credit Rating Risk in Debt Mutual Funds

  1. jaideep

    In fact, J P Morgan AMC has just put out a notice on its website, limiting redemptions from JPMorgan India Treasury Fund and JPMorgan India Short Term Income Fund.
    https://www.jpmorganmf.com/inec/en/Addendum/JPMorgan%20India%20Short%20Term%20Income%20Fund%20and%20JPMorgan%20India%20Treasury%20Fund.pdf
    The need to chase returns results in lower investment grade securities being selected at times, this is one such case. Some years back, liquid funds faced the same problem, as real estate company securities saw a drop in value and RBI had to provide a special facility to MFs to take care of possibility of large liquid fund redemptions. In general, the rule, no pain, no gain holds true, so investors also need to be careful.

    Reply
  2. jaideep

    In fact, J P Morgan AMC has just put out a notice on its website, limiting redemptions from JPMorgan India Treasury Fund and JPMorgan India Short Term Income Fund.
    https://www.jpmorganmf.com/inec/en/Addendum/JPMorgan%20India%20Short%20Term%20Income%20Fund%20and%20JPMorgan%20India%20Treasury%20Fund.pdf
    The need to chase returns results in lower investment grade securities being selected at times, this is one such case. Some years back, liquid funds faced the same problem, as real estate company securities saw a drop in value and RBI had to provide a special facility to MFs to take care of possibility of large liquid fund redemptions. In general, the rule, no pain, no gain holds true, so investors also need to be careful.

    Reply
  3. bharat shah

    'To lower credit risk and interest risk, I would shun every other debt fund category except ultra short-term funds and liquid funds.'
    in a sense, the once long term papers become the short term or ultra short term, and they could be part of ultra short-term funds and or even of liquid funds on the passage of times. So it may happen that even your ultra -short funds holding such deteriorating papers become more credit risky. If I am not wrong, the credit quality change of F.I. UST BOND FUND- S.I. Plan by VRO - from High to Medium happens within 1-2 days, I think due to credit rating change for Jindal group companies. Otherwise also, the default of principal logically happens at the the time of maturity of the papers, so the ultra short term debt funds holding such papers risk is not less.

    Reply
    1. freefincal

      Agree with you. The portfolio of such short-term funds also matter. However as long as the default is not real, the funds will recover back fast.

      Reply
  4. Priya

    What are your thoughts on the fact that-
    1) they have lend to JSPL at SBI+100 bps/50 bps. Don't you think its too less of a return they are looking at considering the quantum of risk taken?
    2) They do not hold any collateral from JSPL?

    Reply
    1. freefincal

      I think there is a collateral (not sure, read somewhere). As for risk vs return, now that bonds have been downgraded, the return will go up

      Reply
  5. Ramesh

    In wake of Amtek fiasco I had sent a email directly to Dr. Mark Mobius complaining about incompetent debt fund Managers in his Indian arm. Specifically pointing at FISTIF I mentioned about 1. Subprime papers. 2. Borrow short and lend long policy. There was no reply from them. Only one way is wholesale boycott of such rouge fund houses by investors.

    Reply
  6. sundararajan

    I have a question on the fund ICICI Prudential Child Care Plan - Study Plan. More than 75% is in SOV or AAA bonds but still returns are very good for past 5/10 years, better or close to equity funds. But all bonds are at longer maturity periods. But I don't see modified duration or other debt fund information on this fund. Of course it has exit load for up to 3 years. Does this fund have low risk and high return ? If you get a chance , let me know. Thanks

    Reply
    1. freefincal

      This is a debt oriented hybird fund. VR does not list modified duration for this. You can check at Morning star or at the monthly report from AMC site. The VR style box suggest that modified duration will be quite high. There is no such thing as low risk and high return!!

      Reply
  7. B. Thomas

    Dear Sir,

    Compared to Bank Fixed Deposit and Banking & PSU debt funds - which is better?

    All the nationalised banks are having problem with NPAs and there are possiblility of credit rating downgrades for such banks. Will it affect the NAV of Banking & PSU debt funds having investment in such banks?

    Even if there are credit rating downgrades of banks having higher NPAs, since the banks are nationalised banks, I assume there will not be any risk of default. So is it possible that the NAV will go up gradually in the long term for Banking & PSU funds having investments in such banks.

    Reply

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