After the sudden interest rate movements seen in recent weeks, mutual fund investors are taking a closer look at credit risks associated with their debt fund investments as the spectre of ratings downgrades looms over India Inc. Credit risk reflects the probability of an issuer of a bond or a money market instrument defaulting on interest payments or in paying back the principal amount on maturity.
“In the current economic slowdown, there is an increased likelihood of credit downgrades and defaults. Both these risks increase in case of lower rated papers,” said R Sivakumar, head — fixed income, Axis Mutual Fund. Ganti Murthy, head — fixed income, Peerless MF, said: “There is uneasiness among investors who are now keen to know the portfolio composition and credit risks involved with their investments.”
Crisil in its report in July had said that the credit quality of corporates was likely to be weakened by slow GDP growth, high currency volatility and higher-than-expected interest rates. “Specifically, stress will increase in sectors such as power, construction, engineering, and steel, and lead to higher non-performing assets (NPAs) in the banking system,” the report stated.
“Fund managers sometimes go for lower rated papers believing they will be re-rated in future. However, this strategy works only when the economy is on an uptick. In the current environment, companies are more likely to get downgraded than upgraded which is why holding lower rated instruments is not such a good idea,” said Vidya Bala, head — mutual funds research, FundsIndia.com.
A large part of the MF industry does not invest in papers rated below AA but there may be some AMCs or schemes that invest in papers rated below AA, according to fund officials. Bala believes that investors should pick schemes where 70-80% of the investment is in AAA-rated papers and avoid funds that invest in sectors such as real estate and infra. Fund officials also believe that most of the recent fixed maturity plans launched by MFs were safe to invest in as a majority of these schemes had invested in bank CDs, which had minimal risk.
Experts maintained that the possibility of funds’ debt investments defaulting remains remote. However, the price of the securities may go down if the credit rating of the issuer of the debt instrument goes down, which means investors may have to liquidate their investments at a loss.
Crisil believes that rating downgrades may outnumber upgrades in the near term and that the pressure would be on firms with higher leverage and longer working capital cycles.