May 01, 2017

Two More Audacious Debt Funds

In response to my last post about the fund that I referred to as ‘Rainbow Fund’, a reader wrote in to say that there were two other debt funds that carried higher risk than that fund.  In his words, these were “the ultimate high risk debt funds”. 

Frankly, such a claim, even if correct, may not have been enough for me to consider doing a post. I might have simply responded to him by email, offering my thoughts.  But there were three things about the funds that he made reference to, that stood out for me.  Firstly, these funds are managed by a fund house that I have believed to have one of the best risk management processes in the industry.  While I was aware that these particular funds were pushing the limits of prudent credit risk, I had not imagined that anyone would compare them with Rainbow Fund.  Secondly, these funds are much, much larger than Rainbow Fund, and hence, there is a lot more investors’ money at stake.  Thirdly, and you can laugh at me, I do not believe in coincidences, and this was the second person to write to me, asking me to do a post about these funds.

Just over a year ago, I received a painstakingly detailed email from a gentleman who wanted me to caution readers against investing in these very funds.  According to him, he had personally invested in these funds but had inadvertently not seen their portfolios at the time of doing so.  Later on, when he did look at the portfolios, he was shocked by what he saw.  He then withdrew his money even though doing so attracted an exit load.  In his email to me, he presented a lot of evidence to support his view on these funds’ riskiness.  While I found a lot to appreciate in it, I also sensed that it was beyond my ability to transform his research into a post that would do justice to his efforts.  For that reason, I suggested that he approach a capable financial journalist instead.  Looking back, I feel that I should have perhaps invited him to do a guest post.

In that backdrop, the intent of this post is to offer my quick take on these funds through the same window which I used to examine Rainbow Fund.  This is, by no means, a comprehensive assessment.  For the purpose of this post, I will refer to these funds as ‘Strip Fund’ and ‘Scorpio Fund’.  Here are some of the facts, based on the disclosed portfolios as on 31 March 2017:

% of Portfolio in Securities Rated A+/ A/A- 41% 68% 74%
% of Portfolio in Securities Rated BBB- 2% 3% 3%
% of Portfolio in Unrated/ Privately Rated Securities 25% 7% 1%
Yield Range of Unrated/ Privately Rated Securities (% pa) 12% – 16% 13% 13%
% of Portfolio in ZCBs Rated A+ or below 6% 24% 24%
% of Portfolio in Unrated/ Privately Rated ZCBs 25% 6% 0%

ZCB: Zero Coupon Bonds

Though the table focuses mostly on credit risk, it gives a glimpse of some of the challenges in trying to assess the relative riskiness of funds.  For instance, if one only considers unrated/ privately rated securities, then Rainbow Fund appears to be taking more risks.  Yet, if you combine these with securities rated A+ or lower, it would appear that Rainbow Fund is taking less risks than the other two funds.  One way to get a clearer picture is to look at the yields of the underlying instruments, particularly those which are unrated/ privately rated.  In that respect, Strip Fund and Scorpio Fund score marginally over Rainbow Fund.

There are other data points, too, which favour these funds but in my opinion, these are all small differences.  The credit quality of the portfolios of all three funds crosses the limits of what I consider to be prudent levels, by a significant margin.  And I find the extent of their exposure to low-grade ZCBs to be disturbing.  I don’t know what the investors in these funds think about all of this but for their sake, I hope that they are at least aware of these facts.

In all fairness, I must point out that both Strip Fund and Scorpio Fund enjoy a high Analyst Rating from Morningstar.  I am not sure if that will continue though, given the dip in the credit quality of their portfolios since the last assessment.

Correction: The exposure of Scorpio Fund to ZCBs Rated A+ or below was originally incorrectly mentioned as 29%.

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