Credit risk funds: Opt if net yield premium over safer funds is substantial

Investors with high risk-bearing capacity may allocate 5-10% of their fixed-income portfolio

Credit risk funds have emerged as the best-performing debt fund category over the past year, with an average return of 10.5 per cent. Schemes belonging to DSP (22.9 per cent), HSBC (21.6 per cent), and Aditya Birla Sun Life Mutual Fund (17.1 per cent) have generated exceptionally high returns over the past year. But experts caution investors against being swayed by these numbers and advise basing decisions on their risk appetite.

 

High Returns May Not Sustain

 

Much of the recent outperformance stems from one-off factors. “They are largely due to write-backs after earlier credit defaults and write-offs. These returns are more of an accounting recovery rather than genuine, superior risk-adjusted performance,” says Vidya Bala, co-founder, PrimeInvestor.in.

 

Fund managers concur. “High returns were driven by recoveries from IL&FS group debt instruments, such as Chenani Nashri, IL&FS Financial Services and other special purpose vehicles,” says Lokesh Mallya, fund manager, SBI Mutual Fund.

 

Returns earned by a few outlier schemes have lifted the category average. “The likely reason for these outliers’ high returns would be recoveries from earlier defaulted bonds and credit rating upgrades that improved valuations,” says Joydeep Sen, corporate author and trainer. 

 

Potential for Higher Returns

 

These funds can enhance returns. “They offer higher yield potential by capturing credit spreads,” says Akhil Kakkar, senior fund manager – fixed income, ICICI Prudential Asset Management Company (AMC).

 

These funds compensate investors for taking higher risks. “Investors may benefit if the lower-rated bonds are upgraded in the future,” says Abhishek Bisen, head – fixed income, Kotak Mutual Fund.

 

Investors may also include them in their debt portfolio for diversification.

 

Credit and Liquidity Risk

 

As their name indicates, they carry significant credit risk. “The larger proportion of investment in low-rated securities increases the probability of default,” says Bisen.

 

Liquidity in a bond dries up when it is downgraded. “Fund managers may be forced to sell downgraded bonds at deep discounts, leading to losses,” says Bisen.

 

During a crisis, exiting these lower-rated bonds becomes difficult, as was witnessed during the Franklin Templeton crisis of April 2020. “Such a crisis will not happen in the government securities (G-Sec) market and is highly unlikely in good-quality (AAA-rated) corporate or public sector undertaking (PSU) bonds,” says Sen.

 

For Seasoned Investors Only

 

Experienced investors who can withstand volatility may go for these funds. “Investors pursuing higher yields, who understand the credit markets and are comfortable with intermittent volatility, may invest in them,” says Kakkar.

 

Conservative or first-time mutual fund investors should avoid them. Bisen recommends they be considered only by those with a medium-term horizon.

 

What to Check

 

Investors should go for these funds only if they offer a higher net yield (portfolio yield to maturity minus expense ratio). “Investing in these funds makes sense if their net yield over better-quality funds—corporate bond funds or banking and PSU funds—is meaningful, around one percentage point. If it is only 10-20 basis points, it does not make sense to take the additional credit risk in these funds,” says Sen.

 

Kakkar advises choosing managers with a strong credit track record, selecting diversified portfolios, and checking portfolio credit quality periodically.

 

Credit risk funds should form only a small part of an investor’s debt allocation. “The allocation to these funds should not exceed 5-10 per cent of the fixed-income portfolio,” says Sen. Kakkar adds that the recommended holding period for these funds should be at least three to five years.