Limit credit fund exposure to 10%-15% of portfolio, advise experts

Go with a fund manager who negotiated the past 5 years without default or downgrade

Credit risk funds outperformed all other debt fund categories over the past year, with an average return of 8.6 per cent (for regular plans). The category, which was earlier shunned, received net inflows worth Rs 796.5 crore between May and July.
 
What led to the outperformance 
 
Franklin Templeton’s decision to close six of its debt funds had led to a run on the credit risk category.
 
“The event resulted in heightened risk aversion, which led to a spike in bond yields of select good quality AA-rated corporate bonds. As the yields cooled off, investors who stayed invested made substantial gains over the past year,” says Manish Banthia, senior fund manager-fixed income, ICICI Prudential Asset Management Company. 
 
Banthia believes risks have come down.
 
“We are positive on the credit cycle as corporate earnings have started to improve and balance sheets are getting deleveraged,” he says. 
 
As the table on yield to maturity indicates, future returns may be more muted.
 
 Watch out for credit and liquidity risk
 
Credit risk funds invest 65 per cent of their portfolio in non-AAA-rated papers. If economic stress rises, some of these papers can see downgrades or defaults. The risk of economic growth slowing down can’t be ruled out.
 
“We have emerged from a big economic shock. The economy is recovering. But a large portion of the population is still under stress,” says Pankaj Pathak, fund manager-fixed income, Quantum Mutual Fund.
 
These funds can also fall prey to liquidity risk. Any time investors become worried about the possibility of a default or downgrade in a fund’s portfolio, many of them try to exit simultaneously, creating high redemption pressure. Simultaneously, selling lower-rated papers becomes difficult in a stressed environment.

Most of these funds invest 20-30 per cent of their portfolio in government securities and AAA-rated corporate bonds, which are easier to sell. But when redemption pressure is high, this component does not suffice, forcing the fund manager to sell lower-quality papers at discounted prices.
 
Redemption risk can’t be managed as it arises from investors’ behaviour. Even a diversified portfolio doesn’t offer adequate protection.
 
“There is a high correlation among weaker companies, which increases in times of stress. If one company within a sector is in distress, many of the other weaker ones also get into trouble. Sometimes the troubles spread beyond the sector,” says Pathak.
 
After Infrastructure Leasing & Financial Services defaulted, other non-banking financial companies found it hard to raise money and some defaulted. Weaker companies in other sectors also got into trouble.
 
Do the due diligence
 
Conservative investors should avoid these funds. Those who have a high risk appetite may take limited exposure. “Exposure to funds that take either credit or duration risk shouldn’t exceed 20 per cent of the debt fund portfolio,” says Kumar.
 
Assess the fund manager's track record in handling credit risk over the past five years. Look up the fund’s net asset value chart. A sharp dip indicates default or downgrade. Avoid such a fund.
 
Also, look up the fund’s one-year rolling return (rolled daily) over five years.
 
“Look at the minimum return which indicates the downside risk,” says Kumar.
 
Go with a fund that declined less.  Opt for a well-diversified fund, so that the hit from a downgrade or default gets limited. Also, ensure the fund you select has adequate exposure to higher-rated papers, which can serve as a line of defence against redemption. Stick to one of the larger funds: small-sized funds come under pressure more easily.
 
After investing, keep an eye on the economic scenario and consider exiting if the environment deteriorates. Finally, watch the fund’s asset under management and investigate if there is a dip of, say, 20 per cent.