Select a credit risk fund that avoided mishap in recent past: Analysts

Given their high-risk nature, take limited exposure in your satellite portfolio

With an average return of 9.4 per cent, credit risk funds have outperformed all others over the past year. However, instead of rushing in to invest in the fund from this category that has given the highest return, investors need to do some due diligence.

One-time gains driving up returns

A few funds, with returns as high as 13-22 per cent, have pulled up the category average.

“Many credit risk funds have seen defaults in the past few years. They had marked down the value of those bonds to zero. Some of them have recovered a part of their money from those papers. That has provided a one-time kicker to their returns,” says Arun Kumar, head of research, FundsIndia.

Funds that did not face a credit event, he adds, have given normal returns – around 1.5-2 percentage points higher than a high credit quality bond fund.

The low interest-rate environment has also enabled this category to shine.

“We were in a very low interest rate environment last year. Credit risk funds, which invest in high yield, low credit quality papers have hence, given better returns. Moreover, no credit event has occurred over the past year,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India.

Returns will normalise

Fund managers remain positive on the category.

“We are positive on the credit cycle as corporate earnings have begun to improve and balance sheets are getting deleveraged, providing additional comfort,” says Manish Banthia, senior fund manager-fixed income, ICICI Prudential Mutual Fund.

Even though spreads have compressed, accrual income is likely to constitute a significant part of bond investors’ returns.

“The spread assets–non-AAA corporate bond space–can provide better carry and margin of safety in the times ahead,” says Banthia.

Many of these funds currently have a yield-to-maturity (YTM) of 6-7 per cent.

“The YTM minus the expense ratio is what investors should expect from them, provided there is no credit event,” says Kumar.

These funds have a low average maturity, and will be less volatile amid rising interest rates.

Credit and liquidity risk

Fund managers can invest up to 65 per cent of their assets in below-AAA rated bonds. Hence, this is an inherently higher-risk category.

Liquidity risk is also high in these funds. Lower credit quality papers tend to be less liquid. When there is panic in the market, investors stampede simultaneously for the exit.

“Faced with redemption pressure, the fund manager is forced to sell the better-quality papers in his portfolio. What remains is papers of poorer quality. Investors who stay put own a portfolio that carries much higher risk,” says Kumar.

Should you invest?

Higher return in fixed income is always accompanied by higher risk.

“Ask yourself whether you have the risk appetite for these funds,” says Belapurkar.

Divide your fixed-income portfolio into core and satellite portions.

“In the core portfolio, which should constitute 70-80 per cent of the total, take neither credit nor interest rate risk. In the satellite portfolio, which can constitute the balance 20-30 per cent, invest in funds that take credit or interest-rate risk to earn higher returns,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Securities and Exchange Board of India-registered investment advisor.

After investing, keep an eye on the fund’s assets under management. “If there is a sudden drop of 20-25 per cent, find out the reason and decide whether you wish to stay put or exit,” says Kumar.

The past five years’ track record should be your key criterion for selecting a fund.

“Go with a fund manager who managed to deal with this period without a credit event,” says Belapurkar.

Check the portfolio. A fund that is predominantly invested in AA or AA-plus papers will be less risky than one invested largely in lower grade papers. The fund’s style box will provide an indication of the credit risk it carries.

Finally, avoid funds with concentrated exposure to a sector, promoter group, or security.