There was a time not long ago when the share markets were volatile when the mutual fund sellers advocated that investors should switch to debt mutual funds claiming that debt funds were safe. They sold debt funds as safe investments, till IL&FS defaults hit the market. Suddenly it transpired that many mutual funds had invested in IL&FS and those mutual funds were saddled with investments that lost a lot of value. Many NBFCs lost money because of IL&FS and again it transpired that mutual funds had invested their debt funds in NBFCs.
Playing on the Investor’s Ignorance
Now there is much debate on whether debt funds are safe for retail investors. Recall my article in this blog (Click here to read it) “Are Debt Funds Safe?” Regular readers will recall that I had mentioned that Debt funds are as unsafe as equity funds, because both funds essentially invest in the corporate sector, which is where the risk is. Advisors suggesting that debt funds are safer than equity funds, are confused on the distinction between risk and uncertainty. An investment in shares creates an uncertainty on whether one will earn dividends, and how much the dividend rate will be. The uncertainty is whether a particular share will give 0% or 10 % or 25 % dividend. An investment in the debt instruments of a company on the other hand removes this uncertainty. The debt instrument (such as a debenture, for example) specifies the rate of interest. When purchasing a debenture from a company the investor knows the rate of interest that he or she will earn.
The uncertainty of “how much I will earn” is removed in debt investments. But the risk of not getting the promised interest rate and the risk of not getting back the principal amount invested remains. The same risks are associated with a share investment. In both shares and debt, the risk is the same. A company that is failing, will fail its share holders as well as its debenture holders. Like in the case of IL&FS or the more recent example of Essel. Risk is the possibility of receiving or not receiving the principal invested and the annual dividends or rate of interest.
Investment in Debt is just as UNSAFE
Mint (11 April 2019) reported that Kotak Mahindra Asset Management Company Limited, withheld part of the redemption from one of its fixed maturity plans (FMPs). Kotak is not the only MF to invest in Essel. Other funds that have been reported by Mint are: SBI AMC, HDFC AMC, Reliance Nippon Life AMC, Franklin Templeton AMC, Aditya Birla Su Life AMC, ICICI Prudential AMC, UTI AMC, etc.
In the case of Kotak Mahindra, two Essel Group companies had apparently made a part repayment of the amount that the Kotak AMC had invested. The default by Essel lead to Kotak FMP not honoring redemption of its MF investors. Kotak took the option of setting aside the debt investment in Essel in one of its FMP while redeeming the balance of the FMP. This is done in the hope that Essel will finally pay up.
A defaulting company is a lame horse – Don’t bet on it
This however is equally risky. It is like betting on a horse that has got lame while running a race, in the hope it will somehow get the strength to win the race. Even large banks are finding it difficult to recover their loans from corporate organisations. They are taking what they call hair cuts, that is settling their loans by writing off more than 50 to 70 % of the amount due. How a mutual fund organisation will recover its investments from a defaulting company is not clear. Will they also take a hair cut?
Investment Risks come in many complicated forms
The layman investor has little knowledge of the numerous ways in which investment risks manifest in risky investments. How is a layman supposed to know that the “safe” debt fund he or she has invested in will in turn invest in a company that will default? There are many ways in which a high risk investment can go wrong. Even experts find it difficult to predict or control the risks in investments. This is the reason that the common investor prefers low risk investments, such as life insurance endowment. Risks in investments can potentially wipe out the entire savings of the individual. Which is why we say