Vodafone Idea Downgrade Again Exposes Mutual Fund Selection Problems

The Ratings Downgrade of Vodafone Idea NCDS once again exposes problems in debt and hybrid mutual funds. What investors can do to handle such credit events

Published: November 20, 2019 at 11:25 am

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On Nov 1st 2019. Rating Agency, IND-RA (India Ratings and Research) downgraded non-convertible debentures of Vodafone Idea from IND-A+ to IND-BBB which is just one rating above “junk”. This affects 35 mutual funds holding such NCDs with a total worth of about 3375 Crores. The full list of affected mutual funds was published yesterday. A look at problems associated with such credit events and what investors should do.

In its report, IND-RA  has stated several reasons for the downgrade. (1) The recent supreme court judgement ordering Vodafone Idea to pay INR280 billion in licence fees (including interest and penalty) (2) banks refusing to waive loan covenants(terms wrt to the usage of funds) (3) delay in monetizing assets for meeting obligations (4) loss in revenue etc.

How Investors should handle the Vodafone Idea Downgrade

Regardless of how much your fund is holding these NCDS – 1% 0r 10% if you are scared that the NAV will fall, an exit is the easiest option. Pull out before any side pocketing drama. However, you can run from credit risk but cannot hide from it.

So the only practical option for those who wish to exit is to stick with FDs and RDs of reputed banks that are too big to fail or the post office which has 100% sovereign guarantee, not just the one lakh insurance. Read more: What happens if my bank fails? All about Deposit insurance (DICGC)

This is because all mutual funds holding bonds, overnight funds, liquid funds, all other debt funds, arbitrage funds, all other hybrid funds and even diversified equity funds are subject to credit risk. The damage is most obvious in the case of debt funds and arbitrage funds since these do not have stock price volatility.

If your fund only has a “small exposure” to Idea Cellular bonds, you can consider holding through this crisis. However, keep in mind that the bond market is extremely illiquid. Redemptions and difficult to offload the bonds could increase in a sharp rise in the exposure.

Funds like UTI Credit Risk Fund  (11% exposure), UTI Bond Fund (7.5%) could get into trouble if they do not act fast.  To their credit fund managers are at it. These funds (not a full listing) have decreased their exposure to Idea Celluar from Sep to Oct.  It is possible that in the last 20 days, the exposure could have dropped further.

Aditya Birla SL Medium Term Plan(G)-0.10
Aditya Birla SL Short Term Opp Fund(G)-0.19
Franklin India Credit Risk Fund(G)-0.12
Franklin India Dynamic Accrual Fund(G)-0.14
Franklin India Income Opportunities Fund(G)-0.09
Franklin India Low Duration Fund(MD)-0.10
Franklin India ST Income Plan(G)-0.10
Nippon India Credit Risk Fund(G)-0.10
Nippon India Strategic Debt Fund(G)-0.09
UTI Bond Fund-Reg(G)-0.13
UTI Credit Risk Fund-Reg(G)0.02
UTI Dynamic Bond Fund-Reg(G)-0.10
UTI Medium Term Fund-Reg(G)-0.14

The only exception is UTI Credit Risk., which one can argue has the mandate to take on credit risk! Investors holding Franklin Ultra Short Term Fund (< 4% exposure) should also not be surprised or worried about this!

Credit Risk Problems with Mutual Funds

  1. There is no credit risk-free category for investors to choose from for the short-term. For example, a fund that explicitly says, “we will invest only in short-term treasury bonds and hold cash”
  2. Arbitrage funds can hold up to 35% of bonds and these can have any level of credit rating.
  3. Overnight funds have the lowest credit and interest rate risk but the corresponding reward will be lower than an FD or RD

Credit Risk Problems with Mutual Fund Investors

  1. Poor understanding of how bonds work in a mutual fund. It is one thing to not understand and avoid and quite another to invest!
  2. Most investors want extra returns from debt funds – because the industry has given then that impression – but do not want the extra risk. This cannot work.
  3. They choose a mutual fund based on star ratings. These ratings do not factor credit quality and offer higher starts to funds with higher returns.
  4. Investors assume the yield to maturity (YTM) is a return measure and choose funds with high YTM. The reality: YTM is a risk measure. Higher the YTM, higher the default risk.
  5. Due to poor training in the financial services sector, advisors match the investment duration with average portfolio maturity. This can be disastrous during a credit event. Read more: Poor Debt Fund Advice: Match Investment Horizon With Fund Maturity Profile
  6. Investors want to protect their capital after buying mutual fund units. This is immature. Those who value capital protection more than anything else should stick to the post office.

Is there any need for debt mutual funds?

Many argue that with EPF/VPF/PPF/NPS there is no need for debt mutual funds. Incidentally, NPS is also a mutual fund! Investors who understand the basics of portfolio management will appreciate the need for a liquid debt instrument for long term goals. This will help rebalance and reduce risk.

Thankfully for long-term goals, we now have constant maturity (1oY) debt funds. See for example SBI Magnum Constant Maturity Fund: A Debt Fund With Low Credit Risk for long term goals! These (or diversified gilt funds) offer the least levels of credit risk.

The interest risk will be high but should be welcomed and managed with regular rebalancing.

For the short term, debt mutual funds offer tax efficiency for those in 20% and 30% or higher slabs.  Market risk is the price to pay for this and lower return is the price to pay for sticking to bank products.  Investors can opt for mutual funds with a history of not taking on risky debt and/or high AUM to reduce credit risk.

In summary, while debt fund avoidance is always an option, investors can with some basic understanding learn to appreciate and accept credit risk by choosing “suitable” products (low portfolio maturity, low YTM, low modified duration and high AUM). Exiting a debt fund at the sight of credit issues and moving to another is not a practical option.

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