The world has turned upside down for debt Investors since September last year, but that does not seem to have unnerved the head of Fixed Income at IDFC Mutual Fund, Suyash Choudhary. For a fund manager who has always been of the view that proper due diligence should be conducted on debt instruments, even ones that are rated AAA by credited rating agencies, last year's washout did not come as a surprise. With investors continuing to flock to the fund house to park their surplus into the Fixed Income segment, Choudhary, who is known to keep a calm demeanour during good times and bad, got into a freewheeling discussion with us on what has been the philosophy of the fund house as far as managing the debt funds are concerned, and what helped them stay afloat during these turbulent times.
Choudhary started off by explaining to us that investors need to understand their risk profile before they park their money into debt mutual funds. As a majority of the investors move to mutual funds from banks, they need to first realize that there is nothing like a guaranteed return in mutual funds. Hence, if the investor has a very conservative risk profile, they should choose an appropriate debt fund that controls both, interest rate risk and credit risk. This came as a breath of fresh air, as it is very rarely that we see fund houses being concerned about the risk profile of investors, before they update us on the risks associated with their products and how investors need to take it forward from there.
Getting Risk Right in Investor Asset Allocation
Choudhary feels that over the last few years there has been a basic problem with how asset allocation has been done for investors investing into debt funds. Risks in debt mutual funds are of two types: He further elaborated with two examples:
For investors in the fixed Income space, risk has always been interest rate risk as it immediately gets reflected in the volatility seen in the daily NAVs. Hence, we used to see scenarios where interest rate volatility would lead to portfolio churning, leading to duration funds being substituted by credit risk funds. According to him this was definitely not the approach to be followed and the reasons are given below:
1. If a conservative investor did not want a long duration fund that carries high interest rate risk, then rather than moving to a credit risk fund, the investor should move to a short term fund with a lower maturity and similar credit risk, that is AAA and Government Bonds.
2. As majority of the debt fund investors are conservative, it would be ideal to park their surplus into AAA funds in the low duration / short term / medium term / corporate bond / Banking PSU categories. On the other hand, investors who are fine with taking risks in their debt portfolio can consider alpha oriented strategies that include Duration Funds and Credit Risk Funds.
Misconceptions about Debt Funds
Choudhary felt that investors should also become more aware of how debt funds work, and not go by common notions, some of which may be wrong. He clarified that most debt fund investors have the following misconceptions:
1. MFs can manage liquidity via exit loads: The normal practice in the industry is to put a steep exit load for credit risk funds as majority of the instruments in the fund will be illiquid papers. According to Choudhary, "MFs are pass through vehicles. They aren't static balance sheets like a bank or non bank finance company (NBFCs) where liabilities may have a defined maturity profile. As has already been shown in the Indian market as well, if the investor concern is strong enough, (he)/she can pay exit load and redeem. In some sense also, the point circles back to appropriate asset allocation. If the investor has allocated to credit risk funds under her predominant low risk bucket, then the likelihood of a panic exit is that much higher when things turn for the worse".
2. If even AAA papers can default, why invest in fixed income: Although we have several recent instances to prove that this can happen, the fund manager is of the view that, "The probability of AAA defaulting is negligible. However, to use a once-in-a-blue moon default and paint a general principle is not advisable at all. Also with some due diligence, the weaker AAA can be generally weeded out by the fund manager in most cases".
We believe that the last line is a clear indication that the strict due diligence done by the fund management team even in AAA instruments actually made them stay away from these instruments. The run up in the AUM of the debt funds of this fund house is testimony to this: From INR 40,091 Crore in September 2018, when the debt fiasco started, the AUM has grown to INR 56,447 crore by June 2019.
IDFC's philosophy to taking credit risk in their portfolios
Firstly, Choudhary said, an open ended mutual fund should have a majority of liquid instruments so as to manage inflows and redemption; this ensures that the discovery of NAV in such a case will be accurate.
The Fund House strongly believes that when it comes to taking credit risks, it mostly revolves around the quality of the fund manager and the depth of the research process, but the bigger question here is, "Is the nature of risk being taken consistent with the vehicle being used to take the risk? More specifically, are open ended mutual funds the appropriate vehicle to take on such positions?"
Our conversation bought to the forefront IDFC Mutual Funds' basic philosophy towards credit risk, wherein they truly believe that Mutual Funds are pass through vehicles. As such, investors can ask for their money any time and the fund management needs to ensure that after meeting the redemption requests, the character of the fund should remain the same in terms of risk profile, concentration of companies, and so on.
We believe that this guidance helped the IDFC MF debt fund management team stay away from taking on greater illiquidity. During times when other fund managers were chasing returns, even if it meant compromising on the risk profile of the papers included in the portfolio, the IDFC fund managers stuck to first principles, and today find themselves in a sweet spot. For the fund house as a whole, recent events have validated this belief. Our debt fund investors are clearly bank FD investors and any turbulence in this instrument gives them sleepless night; and it is these investors that are today including IDFC Mutual Fund along with a handful of other fund houses in their fixed income portfolios.
As for our recommendations, we have been recommending IDFC funds for investments of less than a year, that is, their Liquid, Ultra Short Term and Low Duration Funds. Recommendations of all the debt fund categories of over this duration as per the risk return matrix are subject to the results of our quantitative model results, and so we would like to wait for this year's model output to take any view on the rest of their funds. Also, considering the volatility in the debt market, we are generally advising our investors to stay at the shorter end of the curve; in this space, they can safely take exposure into funds from IDFC Mutual Fund.
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