INSUBCONTINENT EXCLUSIVE:
By Rajeev ThakkarA quick question
You have a choice of lending say Rs 1,00,000 to
a) The Government of India, where there is no chance of you not getting the money back
This is completely SAFE.
b) You can lend money say Rs 5,000 each to 20 borrowers of which you expect one will not repay the money.
Which
option should you choose
The answer really depends on the interest rates
If the Government of India paid an annual interest rate of 7%, at the end of the year, you would be left with Rs 1,07,000.
Let us say the
private borrowers are paying an interest rate of 15% p.a
Now when you lend Rs 5,000 each to 20 borrowers, 19 borrowers are expected to repay with interest and 1 borrower will default
In such a scenario you are left with Rs 95,000 + Rs 14,250 (interest on Rs 95,000) giving a total of Rs 1,09,250.
In this case, despite the
default, the private lending has turned to be profitable.
Recently, there have been a few prominent defaults and some debt funds are
This has led to a flight to safety
If there were to be zero defaults in corporate bonds, why would they pay an interest rate which is higher than the government bonds
That a
lot of bank loans to corporates have turned bad is well known
Is it realistic then to expect that corporate bonds held by mutual funds will have zero defaults Obviously not
My take is that corporate defaults are a feature of the product and not a bug.
This is not to absolve mutual funds of all blame
The following needs to be done to ensure that there are no unpleasant surprises and blowups in future.
Clearly specify the risk in debt
Debt funds carry interest rate risks as well as credit risk
They should not be sold as risk-free instruments
All that can be said is that they usually carry lower risk than equity funds.
The mandate to take credit risk does not give fund managers a
licence to run concentrated portfolios or to take large sectoral exposures or to blindly trust rating agencies or to do quasi lending
operations instead of investing in bonds.
Standard procedures should be put in place by the board and trustees to ensure proper valuation of
the debt securities in the event of defaults and the proper implementation of side pocketing mechanisms as per regulations.
Debt mutual
funds have a place in client portfolios based on their needs and risk profiles
Interest rate movements and periodic defaults do cause the NAV to fluctuate in the short to medium term
If the relevant risk mitigation mechanisms are in place and if the risk and suitability aspects are taken care of when the clients purchase
the product, it is possible to make the working of debt funds boring and not cause periodic headlines in the press.
(Author is chief
investment officer at PPFAS Mutual Fund)
