Credit risk funds back on investors' radar as debt paper spreads widen

Despite the turmoil in the debt market, savvy investors are reconsidering their stance on credit risk funds, thanks to widening of the spreads between AA- and AAA-rated papers in the last few months.
 
The spreads between one-year and three-year AAA and AA-rated papers have widened to 100-150 basis points (bps), according to experts. The spreads differ depending on the sector and companies that issue the papers -- for instance, it could be as low as 50 bps for papers issued by manufacturing companies and 100-150 bps for non-banking financial companies (NBFC) papers.
 
MFs don't go below the long-term A-rated paper but they can technically go up to BBB, which is considered investment grade, said experts. Going below this requires the permission of the fund's trustees.
 
Credit risk funds are open-ended schemes that purchase lower-rated papers to generate higher returns. They typically invest 65 per cent of total assets in corporate bonds that are at AA-rated or below, and are usually suitable for investors with large risk appetite.
 

“There is decent money to be made in these funds over the next few years, about 10-20 bps more than the net yield to maturity of the underlying portfolio,” said Ashish Shanker, head – investment advisory, Motilal Oswal Private Wealth Management. “With the spreads expanding, there is an opportunity in this space. However, the panic has led to outflows in recent months,” added Dwijendra Srivastava, head – fixed income, Sundaram MF.
 
Investors need to analyse the scheme’s portfolio carefully before investing, said experts. This may involve peering through the company’s fundamental health, its repayment capacity, past track record and the debt it has on its books.
 
Lower-rated papers offer higher interest rates and the possibility of mark-to-market gains if the papers are re-rated. “Investors should use a bottom-up approach, look at the company first and then take a decision, rather than basing their decision on an improvement in the economy and the chances of upgrades,” said Srivastava.
 
The lumpiness of investments also matters. For instance, if two fund houses have 40 per cent of their portfolio in below AAA-rated papers, invest in one the portfolio which is spread across 20-30 papers rather than the one invested in 10 papers. “The more granular the portfolio the better as your risk will be spread over many issuers. The exposure to a single issuer should ideally be restricted to 3-5 per cent,” said Shanker.
 
Experts believe that investors take into account their own risk profile rather than spreads before investing. They also caution that there is a possibility of spreads increasing further and the risks may not be fully priced in.
 
 “Investors could look at corporate bond funds and select medium duration funds that some exposure to AA rather than invest in credit risk funds,” said Vidya Bala, head – MF research, Fundsindia.com.
 
“The spreads may have widened between AAA and AA-rated papers but investors will be better advised to stay in liquid schemes till most of the known negative factors have been resolved. Essel and DHFL papers, for instance, are maturing in September 2019, and if anything goes wrong on any of the above, investors in the credit space are likely to be in a deeper mess,” said Sunil Jhaveri, a debt fund advisor.