Vodafone Idea Bond Downgrade: What should debt fund investors do?

A discussion on what affected investors should do after the Vodafone Idea bond downgrade. Affected mutual funds have started side-pocketing their exposure.

Image of a traveler turning his back on an arrow representative of investor feel and react to the Vodafone Idea bond downgrade

Published: January 27, 2020 at 1:16 pm

Last Updated on

On Jan 24th 2020, CRISIL announced that Vodafone Idea bonds would be ranked below investment grade paving the way for AMC to side-pocket their exposure. Franklin has already announced this. Others like UTI, Biral and Nippon India are also expected to follow suit. A discussion on what affected investors and in general all debt fund investors do.

A detailed faq on What is a ‘side-pocket’ in mutual funds? How does it work? was published yesterday. For those who do not understand this idea, we recommend you read the FAQ and then come back here.

What should Vodafone idea affected debt fund investor do now? They need to recognise that almost all of the affected funds have risky bonds in their portfolio. So another credit event could happen at any time.  Risk has not ended once the side-pocket has been created.

If they need the money with the next 12 months, they should exit from the main portfolio of the fund (the segregated section is locked out). If they can wait longer than 12 months, they should ask if they are okay with keeping money in risky debt funds? A bit too late to ask that. Nevertheless, if the answer is “yes”, they can continue.

Rest assured, an AMC like Franklin will have to dabble with credit risk to offset this loss. So one should be prepared for this. Also, to reiterate, this loss is permanent (due to the delay) even if Vodafone Idea honours all its payments.

Remaining invested in the fund because of the side-pocket makes no sense. Even if you exit all your units in the main portfolio, the segregated section will remain as it is.  Investors should exit if they need the money soon or had invested without understanding risks.

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Bond credit rating changes are a daily event in the bond market.  Bonds slipping below investment grade occur quite frequently too. The problem is these changes are not taken into account when star ratings are computed.

So investors assume star ratings imply a “good portfolio” and also get enticed by past high returns. A return of 8.5% or 9% is impossible without the associated credit risks. Those who do not understand these must exit from all debt funds or should learn more about them as soon as possible.

This Voda Idea credit event is neither the first of its kind nor the last that we shall see. Those invested in risky debt funds, whether they are affected by this credit event or not should introspect why they invested in the first place, fill gaps in risk perception and get ready to face the music in the past.

An argument put forth by some investors is, “why to take the risk?”, why not stick with RDs, FDs, overnight funds or good liquid funds?”. Yes, we certainly can. There will be a price to pay here too. More taxes, lower returns and reinvestment risk as interest rates head south in future.

Also, it literally takes all kinds to make up a market. We need a robust bond market across all segments and not just for gilts for the health of the equity market. If we do not fund smaller companies and buy only AAA rates bonds, our economy cannot prosper.

However, investors need to be altered to credit changes at an early stage. For example, A downgrade from AAA to AA is barely noticeable in the NAV. SEBI should introduce valuation measures and make the drop significant. This will at least alert risk-averse investors to pull out before bigger falls.

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4 Comments

  1. sir
    if an investor exit the effected fund now and later vadoidea pays back all dues to the fund, will this investor get his share from side pocketed portfolio or all advantage will go to investors who were invested at both the occasions of side pocketing and pay back by vodaidea.
    regards

  2. Sir, I wasnt quite clear on the below part from this article:

    Also, to reiterate, this loss is permanent (due to the delay) even if Vodafone Idea honours all its payments.

    Why does this result in a permanent loss even if they get paid back? Is there any post/article when I can read more about this?

  3. I have seen a trend where FPI pull out money from debt funds much before bad news hits. Eg: UTI mutual funds hit by DHFL defaults, the exits start happening even before the NAV downgrade. Only indivuals are stuck with such bad funds post the downgrade. On the top it looks like FPI were actively monitoring the fund hence choose to exit but insider trading laws dont apply to debt funds. So its very possible that a backdoor channel between FPI and fund managers can help them exit before downgrade. Question is how do we monitor and avoid such things?
    A large investor also has much more monitoring protocols in place to exit before crisis strikes. Only the small investors get the news from papers and then have to choose to take corrective action. Its not a level playing field.

  4. You have covered debt funds well before but need to write more about specific funds from different fund houses. You should look beyond Franklin. This issue was like disaster waiting to happen, most of the Franklin short term funds are like credit risk funds has more of AA & below with much less AAA compared to competitors.
    Debt mutual fund is still a good option laying between Bank FDs & Equity MF, At least for the people nearing retirement without pension. Need more coverage like equity funds from people like you.

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