We had quite a few happenings with respect to reputed firms running up defaults on their bonds. Some banks also ran deep into a similar mess, so much so that the RBI refused to allow extensions to their CEO’s. It is a good time to reflect on the takeaways.
Liquid Funds Are Meant to be Liquid
We all use liquid debt funds to park cash for any emergency requirements or for short term requirements. Liquid funds are a subclass of debt funds and they invest in bonds of the government or other companies. The investee companies promise to return the interest and sum invested.
The IL&FS Saga
Some debt mutual funds had an impact in September, as they invested in IL&FS group companies. IL&FS is not able to service its debt and as a result, its bonds have fallen in value. Rating agencies which till recently gave it a very high rating (A1+ as recently as August 2018) have now marked it as D.
This rating downgrade of IL&FS was sudden and took all by surprise. Mutual funds had to mark down the value by about half. One such fund is Principal Cash Fund which has been a consistent top performer till recently. IL&FS holdings are approx 10% of this fund.
How Should The Investor React?
As a result, this fund has incurred two drops in the NAV. The fund has already taken a majority of the hit in its NAV. We estimate that if they were to write off the entire investment in IL&FS, this fund could further fall by 2%.
In the past there were two such instances: Amtek auto where one fund took a high exposure; 85% of funds were eventually recovered. Another was JSPL where % of funds were recovered.
The fund hasn’t yet sold off the IL&FS paper which means that it will try and recover some part of the holding. LIC is also interested in fixing up things. SBI and HDFC are also involved. Therefore if there is a bailout, your NAV might recover.
To sum up, the two takeaways from this episode:
1. Do not seek the highest returns in liquid funds. Need here is safety and hence funds that invest in 90-day T-Bills or Short term G-Sec are preferable. Quantum Liquid Fund is one such recommended fund.
2. Diversify one’s holdings even in liquid funds. It is almost impossible to identify risk in one company/fund. Since even rating agencies find it difficult to identify risk 100% accurately, diversification is the best solution for an investor, across and within fund classes.