Time to switch out from credit risk funds?
Head of Fixed Income & Products
Kotak Mutual Fund
WF: How severe is the refinancing risk for NBFCs? To what extent do you see this creating credit situations in credit risk funds? Are we seeing heightened redemptions in credit risk funds? Should we be worried about credit risk funds?
Lakshmi: There are liquidity challenges that we are seeing today. The refinancing issue is name specific in the NBFC space and it is unfair to categorize the entire sector or segment and paint it all with the same brush. Are we facing a deluge of outflows from credit risk funds due to this event? The answer is clearly, no. This issue is again quarantined into couple of names among credit risk funds which have exposure to the NBFCs facing challenges. At this juncture, if someone wants to trigger the panic button and wants to switch his holding from a credit risk fund to an ultra-short term, it may not be a sound move. This type of switch should be triggered only if you have a strong belief that the fixed income market has completely collapsed and does not show any signs of revival, which is clearly not the case here.
WF: What gives us the confidence that the current refinancing issue is unlikely to affect credit risk funds?
Lakshmi – There will be a mark to margin impact on the mutual funds depending on the movement in yield. We are not witnessing a solvency issue within the NBFC sector. There is little bit of sporadic liquidity pressures and this is primarily focused on a couple of specific names. This is similar to the banking system wherein some banks could have a slightly higher liquidity as compared to other banks. This is not a solvency issue, there is a liquidity problem specific to some NBFCs. There could be ripple effect in yield terms, but one need not blow the issue out of proportion at this point, this will not help the yields.
WF: You mentioned that the redemption pressure is not alarming, to get this into context – let’s assume hypothetically, before the IL&FS issued happened, if Rs. 100 was the amount redeemed in a month in credit risk funds, what is the amount today?
Lakshmi – So, pre-ILFS issue, if our net inflows in the industry in credit risk funds was Rs.100, today it is 0. If we aggregate flows across credit risk funds and medium term funds (where too we have non AAA instruments exposure), outflows would perhaps be in the region of Rs.20,000 crores – which is not an alarming figure. At specific fund house level, some are facing more pressure than others – based on perceptions of credit quality in portfolios. So it is not an industry issue as we see it today. That said, the issues relating to NBFCs in general and HFCs in particular need to be addressed at a broader and higher level, to ensure that we don’t get into an unnecessary crisis kind of situation. As far as the MF industry is concerned, it is handling the liquidity issue quite comfortably at present.
WF: Given that the underlying bonds that credit risk funds buy are not very liquid, a net inflow situation into these funds is one of the biggest sources of comfort for existing investors, whose exit is guaranteed by flows rather than sale of underlying securities. Given that we are no longer in a net inflows situation, is it time now to track net flows into this category very closely in the coming months to understand the liquidity risk in these funds?
Lakshmi – If redemptions are heavy and net outflows keep rising, there will clearly be a problem – not just for credit risk funds, but also in the space of higher rated bonds as well. We are nowhere near such a situation, so I would not be overly worried about the industry facing crunch times in credit risk funds. As I mentioned, the need of the hour is for a resolution at a broader level on the issues relating to NBFCs/HFCs to ensure things do not worsen from here.
WF: Mark-to-market losses due to rising yields are making returns on credit funds appear unattractive – which then can precipitate redemptions even as we in the industry argue that YTMs in these funds make them very attractive as investment propositions. How do we tackle this phenomenon of investor despondency at a time when fund managers see huge value?
Lakshmi – I think the key is to have a conversation with every such investor and remind him of the time frame he had in mind for his credit risk fund investment. Most investors come in with a 3 year perspective. On a 3 year return basis, credit risk funds – despite the recent MTM hits – have yielded a return of 7.5% - which is better than gilt funds and better than fixed deposits, especially on an after-tax basis. Looking at every rough patch in the highway to decide whether to continue driving or stop the journey does not make sense. Every journey will have some rough patches – we learn to navigate them and move forward towards our destination. What you lost in terms of MTM hits due to rising yields, you make up in the next leg of the journey from higher YTMs. Its like accelerating in smooth patches and slowing down in rough patches on the highway. The last 3 year return of 7.5% was not achieved in a linear fashion of 7.5% each year – we saw smooth and rough patches then too, and we will see smooth and rough patches going forward too.
Somebody who simply does not want any rough patch in his investment journey can certainly opt for FDs – but then he gives up on a significantly higher post tax upside due to that decision. Our job, and that of our distributors and advisors is to constantly remind investors of this trade off and to give them the confidence that this trade off is and will remain a sensible one.
WF: If a new investor has a 3 year horizon, would you advise him to invest in credit risk funds or suggest parking them in short term and ultra short term funds?
Lakshmi – The AAA and non-AAA spread has clearly widened, there is a higher risk premium attributed and given the marked to market impact, the gross yields of the portfolios held by these short term funds are comparatively attractive. The gap between Government bonds and AAA bonds have also widened, it is not an imprudent idea to selectively invest in high quality credit instruments (namely AAA) over the short duration. Overall, the investor should have a combination of short term funds and credit risk funds.
I would advise the investors to diversify the portfolio across duration (short, medium and long) and credit risk (Government bonds, AAA, non-AAA) to achieve best long term returns. Given the volatile times in credit risk funds, we suggest staggering the investment.
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