Are Debt funds, stimulant for next crises in India?

Pankaj Singhania, Founder Lakewater Advisors.

With the spread of COVID19, economy is undergoing a crucial phase right now. However, there wasn’t any news in the financial sector that created a shocking wave, until Franklin Templeton made a blaring news. In this lockdown phase, Franklin, voluntarily chose to lockdown six of its debt mutual fund schemes. Lakewater believes, corona wave was a mere catalyst and not the reason for Templeton’s meltdown. We have a wrong conception that debt funds offer steady returns, with tax benefits and keeps the principal intact.

Underlying Risk:

Why did Templeton breakdown? Because its strategy was set up for same. Let’s understand the roots of debt structure. The money collected from the investors can be invested in government securities and corporate debt. Since, the former carries zero credit risk, it provides low interest rate. If entire amount is invested in it, high chances are that they might not even beat fixed deposits’ return. This pushes them to invest in corporate bonds which aren’t risk-free. Since, there are no free lunches in debt market, they invest in high credit risk funds to give high returns.

Debt Free Companies:

In 2019, majority of the stocks that were virtually debt free saw a rise, to an extent of 122%. 54 out of 95 companies that are listed in BSE500 index and have ~zero debt-equity ratio delivered positive returns. In the current environment, debt-free companies are safer investment option. Leverage helps the company to execute growth. However, a single dip can bust the companies having high debt-equity ratio. Most of the blue-chip companies are debt free or having low debt-equity ratio and thereby, depict strong financial positions.

Looking for Fixed Return:

Debt Funds and Fixed Deposits are meant risk-averse people. Debt Funds are showcased as superior due to tax efficiency and better returns. Is it so? Are they safe? After, II&FS default, the vulnerability of debt funds is exposed. So, if you seek guaranteed return, Debt Funds are strict NO. Interestingly, the difference between returns of debt fund and fixed deposits isn’t much but the risk is. So, why would Debt Fund be a choice for risk-averse -people over Fixed Deposits? 1

Credit Rating:

Are credit ratings trustworthy? Credit downgrades take place, but it once in blue. However, in recent times, debt failures have been mounting and were off guarded by credit agencies. Be it IL&FS default, DHFL trouble or Franklin meltdown, none were caught by raters on time. And this is a worrisome factor. It’s irony that the credit rating agencies are paid by bond issuer. The non-disclosure agreements, also acts as hindrance for transparency. High time, SEBI should wake up and align the regulations.

Conclusion:

Is Debt Market sound in India? Is the magnitude of safety, high? Lakewater has negative opinion. It may be premature, but the market isn’t comfortable. Over the years, India has tried to capitalize debt market and provided incentives to increase the participation but result is sluggish