IN THE NEW YEAR, it is important to take note of the lessons we learnt last year. For Indian investors, the first lesson is that the equity market will not always move upwards. The second is that even debt instruments carry risks. Investors in some debt funds, especially credit risk funds, were in for a shock when they realised that debt funds could result in a loss for the investors.
A credit risk fund is a category of debt mutual funds. The Securities and Exchange Board of India has defined these funds as the ones that invest a minimum 65 per cent of the fund corpus in securities that have AA or lower ratings. In other words, these funds cannot invest in top rated (AAA) debt instruments. As the investment is not in the best quality of debt instruments, the interest paid by the bond issuer is higher. Accordingly, while the risk associated with the investments these funds make is higher, so is the opportunity for a better return.
As highlighted above, these funds invest in bonds issued by companies. Since September 2018, several such companies defaulted on their repayment commitments. This has affected not just the returns that an investor earns, but, in some cases, also hit the invested principal amount itself, thereby depleting the invested capital.
While it is true that these funds have had a turbulent year, that alone should not cloud our judgment. One of the most important aspects that financial experts look at is the prevailing bond yield spreads. In simple terms, this is the difference between two bonds of similar tenure, but having different ratings. This indicates the premium that an investor can demand or gets to invest in a lower rated instrument. If we apply the yield spread to credit risk funds over the Reserve Bank of India’s repo rate, the spread as of November last year was in excess of 4 per cent. Since 2011, the average spread has been in the range of 3 per cent.
Once you have shortlisted credit risk funds for investment, try to understand the investment process followed by a specific fund. A good fund house will have a clearly defined process in place that will reduce the risk while maximising the returns. This is done by identifying opportunities in the large debt market. Currently there are about 1,000 companies that are rated ‘A’ and above by credit rating agencies, and only about 500 of these have been tapped by mutual funds. This means that mutual funds still have half of the pool to scout for opportunities. Other than credit ratings, mutual funds also analyse the track record, cash flow, asset quality and business risks of these companies.
Once the asset management team of a mutual fund has an investment and risk management system in place, they need to adhere to their defined philosophy. This includes time-to-time review of the investments based on the changing risk reward as well as other macroeconomic parameters. That being said, when a fund house follows its defined philosophy, it will not be swayed by sudden movements in the yields of different securities. Rather, it will stick to its investments if the fundamentals are strong and in line with the defined philosophy. At the same time, the investments also need to be adequately diversified.
The past 12-15 months have brought to the fore some instances where credit risk funds went against the ideal expectations of an investor. However, there were some credit risk funds that remained unscathed despite several defaults from bond issuers. Between September 2018 and October 2019, for instance, 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.
Takeaway:
Consult your financial adviser while taking into account the fund selection. Further, entrust your investments to a credit risk fund with a highly dependable track record across interest rate and credit rating cycles. With potential to deliver out-sized gains for the marginal credit risk they take, these funds should find increased allocation in portfolios of investors who have the ability to tolerate risk.
Author is managing director of Assetz Premier Wealth Advisory.