Red flags to watch out for before investing in debt MFs

It is very unfortunate to see debt mutual funds, which are considered to be the safest option when compared with equity, are surrounded by back-to-back bad events such as IL&FS fiasco, Essel & Dewan Housing Finance Ltd (DHFL) defaulting on payments and getting downgrades from the credit rating agencies. The debt mutual funds, having high exposure in their papers, got adversely impacted. The debt mutual funds that held debt securities of Essel and DHFL amounted to around Rs 7,524 crore and Rs 7,041 crore, respectively. Not just that but recently, there was a Franklin episode that was created due to liquidity issue. Unitholders are still not having their monies back. Having said, debt mutual funds still retain their status of being one of the safest avenues of investment, but investors do need to check some of the things before investing in debt mutual funds.  

 High exposure to one issuer  

If the debt mutual fund is more inclined towards a single issuer, then that is an alert! As that fund is sitting on different instruments issued by the same company, there is a company-specific risk. Say, if the company starts running into losses and is not in a position to honour the payments, the mutual fund, having an exposure to such a company, could be a huge risk. Even after one or two downgrades, it can have a huge impact on the fund’s performance. Though no fund can hold more than 10 per cent of the total assets in securities of one company but anything more than seven per cent of the total assets can be considered to be an alert.  

High exposure to low-rated securities  

In order to earn high returns, debt mutual funds usually take help of the low-rated papers as these provide higher interest rates. Though nothing is wrong with it; however, at times, debt mutual funds go heavy on investing in these securities, which makes the overall portfolio, quite risky. Credit ratings are one of the means through which, you can gauge what is the probability of borrower making debt repayments. Low-rated security means that there are fewer chances of borrower honouring the debt repayment while high-rated papers mean that the borrower is likely to honour the debt repayment. Even though the low-rated papers increase the probability of returns yet at the same time, it carries huge risk with it.  

  Ratings under review  

Investors usually are more inclined towards the actual credit ratings and changes in the same. However, it actually makes even more sense that investors must look out for securities which are under review by the credit rating agencies. This is the time when credit rating agencies re-assess the credit profiles of the securities and decides whether to upgrade, downgrade or keep status quo. During the assessment, if the rating agencies found that the issuer is no longer in a good position to honour the debt repayments, then they downgrade their ratings.  

Now, your natural question would be as to how this is going to be of any help? To begin with, you can check the recent developments that are happening with respect to that issuer with this information. Besides, this will also help you to gauge the outcome of the credit ratings that are under review, in advance. Nevertheless, the basic thing to remember is that the downgrade or upgrade is not just based on the issuer or the company but also on the instruments and tenure of those instruments. There is a possibility that due to a huge loss in the short-term, the rating agencies may have downgraded the short-term instruments but still has a status quo on the long-term instruments. So, don’t take any decision in isolation.