Risky credit funds

Tuesday, September 18th, 2018

Last week there was a downgrade of the debt rating of IL&FS and its subsidiaries by several notches. This is having a ripple impact on the mutual fund industry. As per a report by Bloomberg Quint:

IL&FS has Rs 2,500 crore worth of rated commercial paper, of which Rs 2,020 crore was outstanding as of July end, subscribed mainly by mutual funds and companies, according to CARE Ratings. Around 12 asset management companies have exposure to various papers issued by the IL&FS group, Bloomberg data showed.

Such an event should not be viewed in isolation. The mutual fund credit risk category has seen a phenomenal growth over the last 5 years. The total assets managed by these funds today is over one lakh crore. This is the size of some of larger banks in our country. Yet, till before this IL&FS event, we had been looking at negligible NPAs. IDFC mutual fund came out with a nice chart last year that visually showed this.

With such a large asset size and exposure to risky corporates, such a situation is unlikely to continue. What’s worrying is that the nature of a mutual fund makes events such as a default hit the investors portfolio directly. This is due the the nature of the fund almost as a pass through vehicle. At least in the case of banks there is some mandated capital buffers to absorb the risk. And, if investors start redeeming funds, there is additional pressure on the schemes due to liquidity constraints.

And so these credit risk and medium duration funds seem to be facing a perfect storm with the macro environment providing strong headwinds:

  • Global factors are pushing our bond yields higher,
  • The rally in oil and the depreciation of the currency will create a drag on growth over the next few quarters,
  •  the government is unlikely to meet its fiscal deficit targets in the run up to elections, and
  •  the spread between government papers and more risky credits is still compressed.

It would be prudent then to reevaluate exposure to higher yield credit strategies and to instead look to higher AAA rated corporate and government papers.

About the author

Rishad is the founder of Kairos Capital. He started his career with Standard Chartered Wealth Management and has extensive experience in markets, particularly in terms of mutual funds and stocks.

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