‘Corporate bond funds may be a better bet for debt fund investors’

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Debt mutual funds had been simply recovering from a number of self-inflicted wounds together with investments in ILFS and DHFL, when SEBI launched its broadside towards AT1 bonds final month, including one other aspect of danger to mutual fund portfolios, when it comes to valuation.

AT1 bonds contractually would not have any reimbursement date, however issuing banks redeem them on the finish of 5 years, as per market observe, although this “gentleman’s settlement” (unacceptable to the regulator!) has been damaged at instances. How these bonds are valued is a little bit of a thriller, particularly within the absence of a deep bond market in India. In now forcing mutual funds to worth them as 100-year devices from 2023, implying a possible deep erosion of their valuation, SEBI has dealt a close to deadly blow to this essential instrument which helps banks meet capital adequacy requirement and allows mutual funds and others to earn a very good return over a 5-year interval. Maybe SEBI’s transfer has been triggered by the nightmarish expertise of traders in Sure Financial institution AT1 bonds through which they misplaced their complete funding of Rs 8415 crores.

Storm clouds gathering for debt mutual fund traders

Even earlier than the most recent AT1 bond valuation storm, traders in debt mutual funds had been caught within the proverbial “between the satan and the deep sea” situation. Rising rates of interest had been exposing their lengthy and medium length fund investments to deep capital losses. On the identical time, low length funds had been offering paltry returns of 3-4%, lower than the prevailing inflation fee.

Low length funds ought to profit to an extent, from rising rate of interest traits. However with RBI persevering with to maintain the short-term liquidity situation in large surplus to counter the affect of the pandemic, the low length funds haven’t seen a big uptick in yields.

What can traders do?

Many schemes from excessive profile fund homes within the Banking and PSU debt fund class, thought of comparatively secure, have publicity to AT1 bonds. With an unsure outlook on AT1 bond valuation, traders can keep away from mutual funds invested in these devices for now.

An alternate that traders can take into account is the Company Bond Fund class. Most mutual funds have an providing on this house. Traders ought to take into account credit score danger and length danger whereas selecting the suitable Company Bond Fund. From a credit score danger perspective, SBI, DSP and IDFC mutual funds have a fairly clear portfolio on this class.

Not all Banking and PSU debt funds have publicity to AT1 bonds. IDFC, DSP and Axis mutual funds’ providing on this house have nil publicity to AT1 bonds.

Nonetheless, given the poor expertise with many debt mutual funds within the final couple of years, traders ought to periodically research the portfolio of their debt mutual funds and exit them, if they aren’t comfy with the fund managers’ credit score danger calls, publish funding. “Mutual fund investments are topic to market danger” is actually not a cliché with debt mutual funds lurching from disaster to disaster from the Franklin soften right down to the most recent AT1 bond valuation subject.

Length danger

Larger the length, increased the danger of capital losses, in a rising rate of interest situation. Together with the portfolio composition, the length of the fund is disclosed within the web site of mutual funds as a part of the month-to-month factsheets. DSP company bond fund has a low modified length of 0.96 years, with a yield to maturity of 4.05%, after bills, within the direct scheme. However the corresponding figures for SBI company bond fund are 2.09 years and 4.9%; for IDFC company bond fund, 2.57 years and 5.29%. To mitigate length danger/potential capital losses in each these funds, traders can take into account making staggered funding, much like a SIP in fairness mutual funds. Within the interim, traders can park their surplus funds if any, in low-risk in a single day funds. Periodically traders can change from the in a single day fund to the company bond fund, as and when market rates of interest rise.

Past Company Bond Funds and Banking/PSU debt funds

To allay investor fears of rising rates of interest and consequent capital losses, IDFC mutual fund has give you new choices to deal with this subject. IDFC’s gilt index funds have a goal maturity date in 2027/2028, and can make investments completely in authorities securities mitigating credit score danger. Traders who keep invested until maturity might not face capital losses. There’s a draw back: within the occasion of a pointy enhance in rates of interest over the following yr or so, the funds might face erosion of their worth, with traders who soar in at the moment getting a greater entry level. Traders can subsequently take into account staggered funding, akin to an fairness SIP. In immediately’s rising rate of interest situation, one can anticipate extra such choices from mutual funds. After the latest bitter expertise with a worldwide fund home, traders can persist with mutual funds backed by giant Indian banks or standalone ones with an impeccable observe file, even for investments in comparatively secure goal maturity date index funds.

Will the Authorities’s generosity proceed?

No debt mutual fund providing can beat the largesse of the Authorities in providing Floating Fee Financial savings Bonds at enticing rates of interest (at present 7.15%, topic to periodic reset). Whereas these bonds don’t supply any tax profit, danger averse particular person traders who’re cautious of the numerous market danger in each debt mutual fund providing and the fixed drum beat of adverse headlines on this asset class, can take into account the Floating Fee Financial savings Bonds obtainable on faucet, from the Authorities of India. Nonetheless, the latest flipflop by the Authorities in chopping the rate of interest by 0.9% after which backtracking in lower than 24 hours, brings a component of uncertainty on the returns of this bond over its 7-year tenor.

The author is a hard and fast revenue investor and erstwhile company banker.

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