Credit risk funds: Evaluate if incremental return justifies the risk

Credit risk funds have delivered a category average return of 9.30 per cent over the past year, which makes them one of the top-performing debt fund categories. However, investors must assess whether the additional return justifies the higher risk these funds carry.  

Key return drivers 

Returns have largely stemmed from accrual income and credit spreads. “The larger part of the returns in credit risk funds were generated through accrual from the underlying securities by capturing the spread available between high grade and credit securities,” says Sushil Budhia, senior fund manager-fixed-income, Nippon India Mutual Fund. These funds invest at least 65 per cent of their portfolios in below-highest rated corporate bonds. 

Falling yields have also led to capital gains. “Yields have trended lower leading to capital gains in these schemes,” says Deepak Agrawal, chief investment officer (CIO)-debt and product, Kotak Mahindra Asset Management Company (AMC). 

An improving credit environment has also supported performance. “The credit rating upgrade to downgrade ratio was more than 2X,” says Budhia. Agrawal notes that in the first half of financial year 2024–25, the credit ratio (upgrades to downgrades) stood at 2.75 for Crisil and 2.20 for Icra. 

Prashant Pimple, CIO-fixed-income, Baroda BNP Paribas Mutual Fund, attributes their performance to narrowing spreads in non-AAA bonds. 

Some funds have made lumpy, one-time gains. “The unusually high returns of some of these funds is possibly due to recoveries from earlier defaults,” says Joydeep Sen, corporate trainer and author. 

Exposure to real estate investment trusts and infrastructure investment trusts (Reits/Invits) has further boosted returns. 

 

Supportive outlook 

The credit environment remains broadly stable. 

“No major credit issues are visible. Some concerns exist around micro finance institutions (MFIs) and unsecured retail lending, but these issues appear to be contained,” says Sen. Rate cuts may drive further gains. “The yield curve is likely to get reset even lower with more rate cuts and liquidity infusion,” says Pimple. 

Allocation to Reits and Invits can help improve medium- to long-term returns and diversify these funds’ portfolios. 

Risks to watch 

Credit risk is higher in these funds than in corporate bond funds. “Any major credit event could impact the returns of these funds over the next one year,” says Agrawal. 

Pimple flags the risk from a slowing economy, particularly in unsecured and lower-segment retail loans. 

Budhia cautions that the tailwind from higher credit upgrades to downgrades may not remain as favourable. 

If trade wars force the central bank to hike rates, that could weigh on returns. 

Is it suitable for you? 

Credit risk funds suit investors with a high risk appetite who desire returns higher than they can earn from AAA-rated products. Anyone investing in this category must ensure that their investment horizon matches the fund’s portfolio maturity. Not all experts, however, favour investing in this category currently. 

“A high credit quality mutual fund category, like corporate bond funds, can provide a net yield to maturity (after expenses) of around 7 per cent, while a credit risk fund would offer around 7.5 per cent. The additional return of 50 basis points is not worth taking the higher risk, especially for investors already taking risks through equity exposure in their portfolios,” says Sen.