Venturing into the deep: Credit funds chase 8.5% yields in risk-heavy seas

Money managers set sail with lower-rated papers in a rising corporate tide

Most credit risk debt mutual fund (MF) schemes and some medium-duration funds are likely to deliver over 8.5 per cent annualised returns in the coming years as fund managers increase exposure to lower-rated papers in these categories.

At the end of April, the average yield-to-maturity (YTM) stood at 8.4 per cent for credit risk funds and 7.9 per cent for medium-duration funds.

Yields-to-maturity indicate future returns.

Data from PRIME Database shows that MF exposure to AA and below-rated papers has risen from Rs 45,641 crore at the end of December 2023 to Rs 51,360 crore in April 2024. This increase has occurred despite investors pulling out nearly Rs 1,350 crore from credit risk funds in 2024 so far.

“Our credit risk fund aims to generate returns by focusing on accrual; therefore, AA and below-rated papers form the core of the portfolio as they offer relatively higher carry. Private corporations have deleveraged over the past few years, and their balance sheets are in good shape. With capacity utilisation increasing, we expect private capital expenditure to pick up, resulting in higher credit demand. We will continue to deploy opportunistically depending on the spreads on these papers,” said Akhil Kakkar, senior fund manager at ICICI Prudential Asset Management Company (AMC).

“We follow a top-down macro approach in determining our credit allocations across portfolios. Today, with improved corporate leverage, a strong growth cycle, and an improved demand scenario, we are comfortable with the credit cycle. Spreads for AA- and A-rated assets are attractive, and hence, in light of a good credit cycle and attractive spreads, we have increased our exposure to AA- and A-rated assets,” said Devang Shah, head of fixed income at Axis MF.

While most medium-to-long-term debt funds have struggled to garner inflows in the past three to four years owing to unattractive yields and a change in taxation last year, credit risk funds took the biggest hit in the aftermath of the Franklin Templeton MF crisis.

The lack of liquidity in the lower-rated debt market during the initial period of the Covid-19 crisis also forced fund managers to take lower risks in credit risk funds, leading to a decline in their YTM differential vis-à-vis other debt funds.

According to Securities and Exchange Board of India regulations, credit risk funds must maintain a minimum 65 per cent exposure to AA and below-rated papers.

Medium-duration funds are bound only by a duration mandate and must maintain a Macaulay duration of three to four years. (A Macaulay duration is the weighted average of the time to receive the cash flows from a bond.)

Deepak Agrawal, chief investment officer for debt at Kotak Mahindra AMC, said the elevated yields-to-maturity of medium-duration funds are partly due to significant exposure to AA and below-rated papers.

“Currently, the view is that interest rates are trending lower. The bond index inclusion also adds to the attractiveness of longer-dated government bonds. Hence, there is a bias to run schemes with a duration close to the higher end of the mandate,” he said.