Is Categorization 2.0 required for Debt Funds?

About 2+ years back, SEBI did what was long required. It undertook a massive and comprehensive relook at the Indian mutual fund space.

And as a result, a big Categorization & Rationalization of Mutual Funds was carried out in 2018, which resulted in overhauling of the mutual fund space.

Post that exercise, it became much easier to compare funds of different AMCs within respective categories, allowed for crisper category definitions and reduced the number of similar schemes.

But now, I feel that it’s a good time to have a deep re-look at a section of the mutual fund categories. This in no way means that previous exercise wasn’t successful. It was an exceptional move that was really needed then.

But given the recent development and new learnings, it might be a good time to make changes and further improve things. I am talking about the debt fund space.

Some time back, I had written why there was no need to revisit categorization to widen Large & Mid cap categories in equity fund space.

But the story is quite different in the debt funds. And even though I am not an expert, there is a genuine need to revisit debt fund categorization.

Reason 1:

At present, we have 16 debt fund categories. And the present categorization is based primarily on the maturity profile of the schemes. The existing guidelines don’t prescribe any credit rating profile for a majority of debt fund categories.

Let me explain this a bit in simple terms.

Out of the 16 categories, only a few have a mandate on the credit quality of the fund’s portfolio.

  • Corporate Bond Funds where a minimum of 80% of the portfolio is to be invested in AA+ / AAA-rated papers/bonds.
  • Credit Risk Funds where a minimum a of 65% is to be invested in bonds/papers below the highest credit quality (generally AAA or AA+).
  • You can also say that Gilt Funds (both types) have credit quality mandates to invest in the government papers.

And there lies the problem. But why is the credit quality not defined for others?

Because there is a general perception that bonds/papers with shorter maturities are less risky. And so are the debt funds holding them. This perception is true but not complete. Risk is less from interest risk perspective. But not exactly from a credit risk perspective.

Suppose you wish to invest in liquid funds or ultra-short duration funds with that perception. Problem is that most of the category definitions (except a few) don’t have any mention of the credit risk these funds can take. Both liquid and ultra-short duration categories are perceived to be of low risk. But fund managers can still go ahead and invest in any low-quality bonds if they want. Why? Because these bonds offer higher returns (with higher risks) and because there are no restrictions in the category definition itself!

If a small and common investor invests in these shorter duration funds, then he is looking at them as an alternative to bank FDs mostly. He doesn’t want to take credit risk (and neither does he understand it to be honest).

And this is where there is a genuine need to be more precise in defining the credit quality of investments that a debt fund can make.

We don’t want investors (looking for low risk) to take on higher risk just because SEBI’s debt fund category definitions allow this to be done. This credit quality definition gap should be filled at the earliest.

SEBI did its bit by creating a separate category for credit risk funds to help. And that was a good move. But many AMCs still ran high-risk portfolios even for funds that belonged to lower risk debt fund categories as well.

So need of the hour is that how much credit risk each fund category can take should be clearly defined. Not just for a few debt fund categories, but for all of them.

And don’t ask me why fund managers would be taking additional and unnecessary risks? It’s very obvious. The managers use workarounds around SEBI’s definition to deliberately expose themselves to high credit risks and generate potentially additional returns. They then generate higher returns than their peers for a year or two in favorable market conditions. Actual risk can be very different from the perceived risk in debt funds and these high returns in good years mask the risk being taken. Many investors get attracted. They don’t understand that the source of high returns is unwanted, high-risk behaviour of these fund managers that can backfire in unfavorable markets.

Post the categorization, most investors pick debt funds based on the categories. Even advisors do that. In a way, the category is used as a proxy of the riskiness of funds. But many times, the actual risk is very different due to the fund’s choice of bonds/papers even within the definition of the category. So clearly defining and restricting how much credit risk each fund category can take will bridge the gap between what’s expected and what’s delivered.

Reason 2:

One more thing that came out in open in recent months is that even though the category of a debt fund may be an indication of the average maturity profile of the fund, the actual bonds/papers held by the fund may be of a longer duration.

So an ultra-short duration category, by definition will have 3-6 months average maturity profile. But it may still hold some bonds/papers which are having maturity of 1-2 years or even longer!

Why? Because the category rule is based on the average maturity and doesn’t mean that each and every component needs to have this maturity limit. Only the portfolio average should be within the definition. So the average maturity can be really deceptive as there’s a big gap between actual maturity/liquidity and what it seems to be at the category level.

Take for example Liquid funds. The definition defines that it can have papers of a maximum of 91-day residual maturity in its portfolio. This is not average. It clearly defines the maximum limit. So there is no scope for confusion. But other categories like ultra-short duration, low duration, etc. define portfolio maturity limits in terms of the average duration.

This is what the problem was in the recent issue with Franklin India’s debt schemes which were winded down (read more).

As per the AMC, the estimated time of return of money to Franklin debt fund investors is much longer than what was perceived by most on the basis of fund category’s average maturity profile.

SEBI needs to look into this aspect very seriously. A small common investor cannot be expected to know the complexities of debt funds and all this. Maybe they should bring in more restrictions on the use of average maturity and promote the use of maximum maturity or some version of it.

Other reasons?

There can be many more. Everybody in the investment advisor fraternity has thoughts and is voicing them. Maybe having some categories clearly reserved for large non-retail investors can also be considered. This way, the categories available for retail investors will be limited to simple, low-risk ones. I am sure there can be many more reasons on how to further improve the debt fund space.

My idea about debt fund has been simple. I neither want to lose my sleep nor allow my clients to lose theirs over unnecessary risk-taking on the debt side of the investment portfolio. Better take risks with equity and not debt.

If you are interested, do read How I pick debt funds?

I was also quoted a few times in Morningstar & also MoneyControl about how to pick debt funds and more importantly, how to set the right expectations from this investment product.

As many of the regular readers know, I am a strong advocate of Goal-based Investing. It is what works with the highest probability for most people.

And debt funds can be a solid part of such a strategy. But before you invest in debt funds, make sure that you make up your mind to link investment to financial goals. It’s the best approach.

Once you are in that frame of mind, go ahead and figure out your risk profile. Not everyone is a conservative investor. Not everyone is an aggressive investor.

Figure out who you are and what your real risk tolerance is? Don’t be surprised if it’s not what you think it is!

And what then?

Get yourself a SOLID Financial Plan that does the job of picking the right equity & debt funds for various financial goals.

Since the last few years when I became a SEBI-registered Investment Advisor, the market regulator SEBI has done great work in the investors’ interest. It will be interesting to see when and how the debt fund categorization, credit quality and portfolio duration norms are reworked.

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