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Over the last year or so, the sanctity of a AAA-rated bond has been shattered. IL&FS is a case in point. Following its default, several AAA- and AA-rated bonds such as DHFL or Zee Group have either defaulted or delayed on payments.

For any type of fixed-income investment, the return is not fixed unless you meet certain conditions, the primary one being that it should be held till maturity. If you hold a one-year fixed deposit (FD) to maturity, you should receive the promised interest. If you break it in three months, you get a lower interest rate. Similarly, with other fixed-income investments such as debt funds, the return is subject to credit risk, interest rate risk and reinvestment risk. If you hold the fund to maturity, you will likely receive the projected yield to maturity (YTM). The big if here is that YTM plays out only when there are no credit defaults or downgrades. The price movement until then is subject to mark-to-market risk and will fluctuate with interest rate movements. In the event of default, the net asset value (NAV) of the fund will fall to reflect the markdown of the defaulting paper in the fund’s portfolio.

So, what should be your strategy regarding debt funds whose value has eroded because of a credit event in some of the securities in its portfolio? How should you determine whether to exit or stay invested? Here are some guidelines:

Extent of exposure: Determine the exposure of the scheme to the security that has defaulted. If the exposure is less than 3%, assuming the remaining securities in the portfolio are in order, you may consider staying invested. This is because the markdown is relatively insignificant and should not affect the yield of the overall portfolio by a large margin. Note that many of the bonds that had defaulted have started paying back their dues, resulting in the recovery of NAVs. If the exposure of the defaulting instrument is more than 3% of the portfolio, you must gauge the scope of recovery of the bad assets. Also, if the remaining instruments in the portfolio are of poor credit quality, the chance of further defaults may erode the value of your investment significantly. In such situations, it is better to cut your losses, exit the fund and reinvest in a better instrument to recover the loss. One sweetener could be the tax offset you receive against other income to the extent of capital losses, thereby reducing your overall tax bill.

YTM: YTM measures the returns of the scheme if the portfolio is held from current date to maturity, after factoring in all the interest payments it will receive until maturity. If the interest rates are high, YTM is high. If, after factoring in the default or downgrade, YTM is still attractive, remain invested.

Yield spread: This refers to the difference in yields between two bonds of the same maturity, but differing credit quality. Given that banks and other lenders are now reluctant to lend to borrowers that are not AAA-rated, these borrowers are willing to pay higher rates. Sometimes these spreads are so high that even if you factor in future defaults or downgrades in the portfolio to the extent of 3-5%, the returns may still be higher than a 100% AAA-rated portfolio. Hence, if you are hunting for higher returns and are comfortable with credit risk and the resultant volatility, you can invest in a portfolio that has a mix of AAA- and AA-rated papers to take advantage of the wide yield spreads.

Exit load and tax impact: Debt funds are tax efficient in that they grow on a tax deferred basis. Unlike an FD, where accrued interest is taxable, you do not incur a tax incidence on debt funds until you redeem. Short-term gains are taxed at the marginal rate, and long-term gains at 20% with indexation. This results in a higher post-tax return compared to traditional deposits, even if the returns on both instruments are the same.

Redeeming your investment entails a tax incidence, where you will book capital gains or losses in the short- or long-term. If you invested a long time ago, you may have accumulated significant unrealized capital gains. Redeeming these schemes because of credit worries may result in a big tax bill. You need to weigh the tax bill against the credit concerns you have. Also, redeeming your investment prematurely may entail an exit load.