Earlier I had written that debt funds are not as safe as they are made to seem by those selling mutual funds. Read the article https://www.helpindiainsure.iistpune.in/2017/09/28/look-where-debt-fund-money-is-invested-by-mutual-funds-and-they-say-debt-funds-are-not-risky/.

Many of my mutual fund friends got in touch with me to tell me I am wrong. They insisted that debt funds are safe. Why then are debt funds showing a negative return today?

Now evidence is falling out of the cupboards. The Times of India reported in their section Personal Finance on 1 October, 2018, that debt funds have invested heavily in high risk corporate debt and the debt funds are now in trouble. This aspect has come to the fore because of the financial crises of IL&FS defaulting on its debt repayment. IL&FS is not the only culprit. The entire corporate sector is in a debt crises of a magnitude they have never been in.

Corporate Sector Debt – The Broad Picture

Today almost the entire corporate sector is in a debt repayment crises. About Rs. 7 lakh crore worth of debt that companies owe banks is under arbitration and the talk in newspapers is that about 70 % to 80 % of this will have to be written off by the banks. There is talk of the figure rising to more than Rs. 10 lakh crores at the end of this financial year!

Companies are defaulting on debenture interest and principal repayments. If this issue of corporate debt is not resolved in an efficient manner there is a strong likelihood of the corporate sector collapsing under the weight of the loans it has taken. The gravity of this problem is such that the Government was forced to take over the management of IL & FS. This is an extreme action and was taken to ensure that the defaults by IL & FS (and its various subsidiaries) do not happen on a large scale. If this happens then there is a strong chance that much of the infrastructure sector (and by extension the whole economy) will collapse.

All these years IL & FS was seen a professionally run company with strong ethics and profitability. Today that image has taken a beating. IL & FS is a very large company and much of India’s infrastructure development is dependent on the company delivering good result. If it fails the chances of a collapse of a large part of the country’s economy is very high. Imagine the case of other companies that are not as big as IL & FS and therefore no government will interfere in their management!

The Corporate Sector and many Countries are Heavily Over Leveraged

To use the language of financial management, today corporate organisations are very heavily over-leveraged. That is to say they have have taken much more loans than what they can service. This is actually a wider problem world-wide. Many countries have taken more loans than what they can service and there are strong reasons to believe that the countries as well as the corporate entities in those countries are at high risk and are leading themselves to a collapse. But this is a matter for a subsequent article.

Why Debt Funds are Unsafe

Coming back to mutual funds. Mutual funds can be equity funds or debt funds or a combination of both. Mutual funds can also be invested in commodities, foreign exchange, government securities, etc. In this article we are concentrating on debt funds. Firstly because mutual fund advisors insist that debt funds are safe (without any scientific basis) and secondly because debt funds are actually showing signs of negative NAVs.

When an investment manager of a debt fund invests in debt and the investment manager takes adequate precaution to make continuous risk assessments and invest according to the risk assessment made, the chances of making good returns on debt funds increases. But what happens in practice is that investment managers, like all investors, are greedy to make money fast. This allows them to personally earn good incentives and increases their market value.

In practice the investment manager invests in higher risk debt in the hope of earning higher returns. The definition of higher risk is not higher returns, but expected higher returns. So it is only an expectation. It may come true or it may not. usually the hope of higher returns on a higher risk investment is based on low probabilities. Which means that the chances of getting a higher return are actually very low. More often than not the debt fund fund ends up in a loss on such investments.

Empirical Data on Unsafe Investments Made by Debt Funds

The Times of India gives data on how much some of debt funds have invested in higher risk debt – they have given data for investments in debt investments in rated AA or less (including unrated debt). I am giving a few examples below:

a. Franklin India Low Duration: 56.2 % in high risk debt

b. ICICI Prudential Ultra Short Term: 47.9 % in high risk debt

c. Reliance Ultra Short Duration: 34.1 % in high risk debt

To put the above data in perspective, it is important to know that short duration liquid funds are usually held as low risk by investors and are compared to bank fixed deposits, in terms of the risk profile. But with corporate entities under severe pressure of not being able to meet their debt obligations, this seemingly low risk type of mutual fund has now become a high risk one. The risks on this are only going to increase in the months to come, because there is no solution in sight for companies being able to meet their debt obligations.

As a result most debt funds are now giving negative returns. Please advice your customers to get out of debt funds as soon as possible. Debt Funds are as unsafe as equity funds. Remember simple common sense – As long as the mutual fund invests in companies, whether equity or debt, the mutual fund remains a risky investment. Risky investments are not for everyone. But more on that later.

For now there is no alternative to life insurance endowment for long term, low risk, low liquidity investments.