Abhimanyu Sharma
As an investor, we all have to master taking emotion-less decisions that see things as they are. Credit risk funds today are at a crossroads. A string of nasty defaults and rating downgrades have separated the men from the boys in the credit risk fund category. This has created a unique situation where funds with a robust risk management process are largely unscathed. Given that investors today understand the true nature of risk in such mutual funds and also understand which funds built an all-weather proof portfolio, it is the right time to form a deeper bond with credit risk funds.
What is a credit risk fund?
Credit risk funds are a category of debt scheme that invest mainly in AA and below rated credit rated securities. By investing in such securities, the funds bet on the potential for credit rating upgrades. Also, credit risk funds can provide reasonable accrual income as they earn interest income primarily from the coupon offered by securities they hold in their portfolio. As on November 2019, credit risk funds managed investor assets of over Rs 64,000 crore.
Credit risk funds can hold 65-100 per cent of investment in AA and below rated securities, while 0-35 per cent in other instruments. Unlike duration based debt mutual funds, credit risk funds play on accrual income and not on interest rate movement. Credit risk funds also do not suffer from high macro event specific impacts, thus making them an all-weather solution instead of remaining a narrow tactical solution.
Why credit risk funds are in the news of late?
Debt funds have got disproportionate attention due to multiple defaults by debt issuing companies and numerous rating downgrades over the past year. This has hurt perceptions about debt funds. Credit risk funds have seen sharp fall in NAVs as valuations of debt securities have come down.
Unfortunately, not all credit risk funds have behaved in a similar manner. For instance, in the 3-year period, one fund has a negative return, five funds have 1-3 per cent CAGR while 12 funds have between 4.0-7.5 per cent CAGR. Clearly, some funds that are well-managed have been able to side-step problems ahead of the crowd. They avoided concentrated exposure, unlike peer credit risk funds that got badly affected when heavy bets on a few credit securities backfired. Also, many disappointed investors moved out of these affected credit risk funds, forcing fund managers to sell good credit and rake in cash to meet redemption.
Good times often come silently
Warren Buffett once said that as an investor, it is wise to be “Fearful when others are greedy and greedy when others are fearful”. This is an apt message for credit risk fund investors today. At a time when credit risk funds are seeing slowing down inflows and the narrative associated with the category as a whole is negative, one may ask why buy credit risk funds? The answer is: Attractive Valuations.
The difference between the yield on a corporate bond and a government bond is called the credit spread. In the current context, the prevailing spreads are attractive, since they are above historical average. Typically when spreads are above historical average, that is when well-managed credit risk funds deliver superior risk-adjusted returns.
How to choose a credit risk fund?
For aggressive fixed income investors, the smart thing to do today is to choose a well-managed credit risk fund that has stood the test of time.
First and foremost, a credit risk fund is as good as its investment process. The investment process should be clear. Safety, liquidity and returns should be the preferred order of priority. A robust investment process will entail strong credit research, stress-resistant portfolio construction and regular portfolio health monitoring.
Secondly, the credit risk fund should have a proper risk control mechanism such as tools for liquidity management, concentration management as well as credit management with keen focus on diversification, and conservative duration management.
Thirdly, the credit risk fund should personify discipline. Being focused on investment process is key. This will ensure that even a seasoned fund manager on occasions does not get swayed by yields alone.
Last but not the least, adequate diversification within securities is a must. This means the credit risk fund should have a good number of different securities that help lower individual issuer exposure, spreads out funds across different credit ratings and limits group/sector exposure.
One such fund has been the ICICI Prudential Credit Risk Fund. Between September 2018 and October 2019, there were at least 22 defaults by bond issuers and the ICICI Prudential Credit Risk Fund had no exposure to any of those. This testifies that the scheme’s and fund managers’ processes are in place and are working well in favour of their investors. Accordingly, a credit risk fund could be considered to be a part of your overall debt portfolio to give the returns some boost.
Abhimanyu Sharma is the founder of Swarn Associates LLP.
