Debt mutual fund managers are facing a tough time, with credit risk of their assets rising in the aftermath of the IL&FS crisis. Logically, to offset this rising credit risk, one would expect them to pile on risk-free government bonds or at the very least hold on to existing ones.
Strangely though, mutual funds have been net sellers of government bonds since the beginning of 2018, and the intensity of the selling has only increased in the months following September. As a percentage of total assets under management of income funds, holdings of government securities had dropped to 3.34% by end-January, from 5.37% in August 2018, shows data collated by Value Research.
One explanation that fund managers offer is that fixed income funds, especially gilt funds, have been facing outflows since the beginning of 2018, which has triggered selling in government bonds. “The duration risk is high given the outlook on interest rates. Investors want to be at the shorter end of the curve now and are moving from long duration funds to that of shorter duration," said Lakshmi Iyer, head of products and debt at Kotak Asset Management Co. Ltd.
This pessimism over long duration bonds—government bonds typically fall in this category—is unlikely to change soon, she added.
Adding to this was the delicious opportunity to easily offload long-term government bonds to the Reserve Bank of India (RBI) through its open market operations (OMOs). The central bank has been one of the biggest buyers of bonds in recent months.
“RBI had done large-scale OMO operations and that had pushed yields down sharply. This sharp fall in yields has given a profit-taking opportunity. Also, when the RBI is buying, it is the best opportunity to sell," said R. Sivakumar, head of fixed income at Axis Asset Management Co. Ltd.
But what the selling of government bonds has done is increase the credit risk profile of debt funds even more. To their credit, mutual funds reduced their exposure to commercial papers (CPs) by over four percentage points to 10.6%, a clear move to reduce credit risk since these instruments were at the epicentre of the liquidity crisis. Recall that questions about the credit quality of non-banking financial companies (NBFCs) had butchered their stocks in September, with some of them losing more than 50% of their market value. In fact, taken together, the exposure of corporate bonds and CPs hasn’t risen as much.
But it’s fair to say that debt fund managers are between a rock and a hard place. Faced with redemptions, the only way to quickly raise cash is to sell the most liquid asset, which is government bonds. Corporate bonds are illiquid even on the best days since the secondary market volume is abysmally low. During tough times when credit risk is perceived to be high, it is even tougher to sell them.
Having said all this, higher corporate credit exposure doesn’t necessarily mean much higher risk, especially if the bets are placed on corporate bonds that are highly rated. “This is the Indian market. We are always yield-hungry as investors want superior returns. When a safer quasi-public sector issuer can give a higher yield, why bother with a gilt?" says a fund manager, requesting anonymity.
The problem, however, is when the above logic leads to bets that significantly alter the risk profile of income funds. The fact that some mutual funds have agreed to standstill agreements with some corporate borrowers, who are facing liquidity pressures, only goes to show that riskiness of some debt funds have gone beyond what investors had bargained for.