Investing in credit funds based on past returns would be foolhardy: Experts

Credit risk funds are showing a category average return of 13.2 per cent for the past year. This is an exceptional figure for a debt fund category. According to experts, however, investing in these funds based on past returns would be foolhardy.
 
Improved credit environment
 
After the outbreak of Covid-19, the Reserve Bank of India (RBI) directed credit to stressed sectors, and made enhanced liquidity available within the banking system. The government provided emergency credit to stave off defaults. The fiscal support it provided boosted demand, which led to an improvement in the credit cycle. “A strong recovery post-Covid contributed to an improved credit environment,” says Devang Shah, co-head fixed income, Axis Mutual Fund.
 
Improvement in corporate balance sheets also provided a tailwind. “Corporates deleveraged their balance sheets significantly,” says Shah.
 
The number of upgrades has exceeded downgrades. Such an environment, says Shah, is positive for the credit risk funds’ returns. While government security yields have hardened in recent times, credit spreads have remained compressed in the broader market. “This is due to demand-supply dynamics. There hasn’t been much issuance of credit papers (AA and below) while demand is good with everyone searching for yields,” says Sandeep Yadav, head-fixed income, DSP Investment Managers. One fund in the category has delivered a return of about 148.8 per cent over the past year. Several others are showing double-digit returns. “Credit risk funds saw the maximum number of write-offs in 2018-2019. Segregation was not mandatory then. Some funds have made recoveries from papers they had written off then,” says Vidya Bala, co-founder, Primeinvestor.in. The returns of these funds have increased the category average. 
 
Returns may reduce 
 
One factor that contributed to high returns was compression in spreads. “Last year, the spread in AA assets over AAA and G-Secs was huge. But a large part of the spread compression is behind us,” says Shah.
 
Spreads may even widen a little. “When interest rates rise, credit spreads tend to widen eventually. Even if they don’t rise significantly, they stop falling,” says Yadav. Rising interest rates are also expected to have a mark-to-market impact.  Liquidity risk can also affect their returns, as this example illustrates. Suppose AAA papers provide 6 per cent and AA 7.5 per cent (spread 1.5 per cent). Redemptions force a fund manager to sell some of his holdings. If he does not find buyers at 7.5 per cent yield, he will be forced to sell at 8 per cent (lower the price). This causes credit spread to widen. The fund’s net asset value (NAV) declines when that happens.
 
Fund managers don’t see much risk of defaults in well-managed funds currently.
 
According to Nimish Shah, chief investment officer-listed investments, Waterfield Advisors, “The current yield to maturity of these funds is 6.5-8.5 per cent. With interest rates expected to rise by 50-100 basis points, expect returns to decline to 5.5-6.5 per cent over the next year.”  

Pay heed to risk management 
 
Pay heed to the steps the fund manager takes to manage risk. “In our fund, we maintain a diversified portfolio. Our non-AAA exposures are in shorter-dated papers. We also ensure laddering of maturities,” says Shah.
 
He explains that with credit cycles becoming shorter, they limit exposure to two-three-year papers in AA and lower-rated bonds. “As they mature, we can reassess their credit quality and reinvest,” says Shah.
 
Laddering ensures that papers mature continuously. This ensures the fund has adequate liquidity to handle redemption pressure. Avoid funds that saw defaults in the past. Bala says investors should also avoid those with corpus size below Rs 500 crore (they come under greater redemption pressure faster).  Shah of Waterfield Advisors advises going with funds that have 50-60 per cent of the portfolio in AA, AAA, and sovereign debt papers.
 
Not for the risk-averse
 
Conservative investors may avoid these funds. Those with moderate to high risk appetite may invest 15-20 per cent of their fixed-income portfolio in them.