How rating downgrade effects Debt Fund of Mutual fund Industry

Four names which become the nightmare are IL&FS, DHFL, Reliance Anil Dhirubhai Ambani Group(ADAG) and Zee / Essel. What is particularly noticeable that in corporate bond instruments not only the ability to repay the bond is important but also the willingness of repayment is also important ,  hence subjective factors are also present there.

Another important point is no cap has now been provided by regulator on promoter's borrowing capacity, which also effects the financial ability of the borrower's.

1. Role of credit rating agencies

1.1 Credit rating agencies generally delay in downgrading funds which itself creates problems, such action puts question mark on the credibility of credit rating. Now regulatory authority has started scrutiny.

2. Mutual fund schemes are affected

2.1 Downgrading of funds from AA+ ( high-grade investment) to D (Investment in default)

2.2 Since October 2018 credit rating agencies have downgraded 319 bonds of 63 issuers, which is more than the total number of downgrades in last 3 years. In coming days more downgrades may happen because of regulatory actions.

2.3 NBFC has also contributed the spike.

3. Meaning of downgrade

3.1 Downgrade means a bond has become more risky  than before, which invokes negative market reaction, which leads to drop in market price and in turn fall in NAV is noticed.
3.2 DHFL delayed in paying interest leading to rating agencies downgrading it's bonds to D grade.

4. Role of SEBI and AMFI

4.1 SEBI and AMFI instructed AMCs to mark down the values of their bonds. Such mark down was discretionary earlier since most corporate bonds held by mutual funds are not frequently traded. Now AMFI has now issued standard guidelines on writing down process.
4.2 Due to new AMFI norms 90 debt schemes reporting a single day fall of more than 5% in NAV.
4.3 Regulator is also advising AMCs to factor the market yields into their rating. Hence more volatility can be experienced by the market.
4.4 SEBI also emphasized market based valuation of liquid funds. Liquid funds return goes down to 4.9%.

5. The positive clues

5.1 The long term interest of the investors is now protected. Changes in rating and mark-down in bond values will help keeping debt funds NAV closer to reality.
5.2 Sudden market reaction may cause sharp fall in NAV and subsequent recovery also. It generally effects the interest of old investors. To protect such interest many fund houses disallowed fresh investments in some of the schemes.

6. How to choose the category:

6.1 Cutting down the 16 category of debt fund into 4  category.
6.1.1 Liquid Fund matures in 91 days they invest in   30-90 days security, in treasury bill, commercial papers, CBLO, money market instruments and cheapest expense ratio 0.10-0.20 % yearly, return is averaged 7.6 % c.a.g.r.
6.1.2 Short-duration Fund is generally lucrative for 3-5 years investment plans. Long duration fund are exposed to interest rate cycles which is hard to predict. It matures 1-3 years. It attracts tax @20% with indexation benefit, average return is 7.8%.
6.1.3 Conservative hybrid funds are suitable for them who are looking to secure return which will beat inflation and at the same time do not want to invest in equity. They invest 70-75% in debt instruments and the balance in equity. Here debt portion will protect the chance of capital loss and equity portion  will provide higher return. Average expected return from such fund for 10 years is 8.7%.
 6.1.4 Equity-saving hybrid fund is more tax efficient. The investment pattern is one third in equity, one third in debt and one third in debt like arbitrage product. It generally returns matching to its debt category with equity taxation features.

6.2 Financial goal will be the primary guiding factor in choosing the right category. Higher rating like AA is another guiding factor, and YTM (yield to maturity) can not be ignored as one of such guiding principles.