Credit risk

Debt funds: Should we bet on credit risk funds?

The search for higher yield in an environment of low interest rates, attractive spreads after the Franklin Templeton episode and abundant systemic liquidity led individuals to invest in credit risk funds. After Franklin Templeton shut down six debt programs investing in low credit rated papers and heavy redemption pressure in April 2020 and concerns over downgrades and issuance defaults, investors redeemed nearly 36,000 crore rupees of this category in 2020.

Last year, the category saw an inflow of Rs 918 crore following a decline in risk aversion on strong corporate earnings expectations amid an upturn in economic activity following the impact of the Covid-19 pandemic. However, this year through March, the credit risk category saw an outflow of Rs 984 crore.

Should you invest?

So, should retail investors take risks and invest in these debt funds? Dhaval Kapadia, Director, Investment Advisory, Morningstar Investment Adviser (India), said that currently the additional yield (spread) offered by credit risk funds compared to funds with shorter duration (corporate bonds, bank debt and PSU, short term) is significantly lower than in the first half of CY2020. “As a result, keeping the risk-reward in the perspective of allocation to credit risk funds should be limited, and one can look to build the allocation in a laddered fashion as valuations become more favorable (spreads widen compared to current levels),” he said.
Pankaj Pathak, Fund Manager, Fixed Income, Quantum AMC advises retail investors to stay away from credit risk funds. “In credit risk funds, the risk return dynamics are not in favor of investors. If all goes well, investors can earn an additional 1-2% return. But there is a risk of losing a big chunk of your wallet if something goes wrong,” he says.

What to pay attention to
Credit risk funds carry a higher risk among debt funds, as debt funds may also invest part of their portfolio in poorly rated companies. Therefore, investors who wish to generate additional returns while taking on some risk opt for credit risk funds. Additionally, liquidity is a big issue as the secondary market for low-rated debt securities has not yet developed in India, which makes portfolio turnover or sometimes even redemptions extremely difficult.

When choosing a credit risk fund, look for funds that are well diversified across issuers and sectors. Harshad Chetanwala, co-founder of MyWealthGrowth.com, explains that the companies in which the fund invests define the credit risk that these funds take on to generate additional returns. “Besides quality, you can also look at portfolio diversification and fund size at the time of investment. Keep your debt fund portfolio equally diversified,” he says.

Investors should review past performance (returns, declines) of the fund and analyze all past downgrades and upgrades to credit ratings, to ensure the robustness of the investment process followed. Also consider the stability, tenor and experience of the fund management team. Kapadia advises diversifying credit risk exposure across more than one fund, in order to limit exposure to betting and/or style to a single manager. “Also be aware of the expense ratio and high exit fees that some funds in this category charge,” he says.

Allocation amount
The allocation to these funds could represent 10-15% of the overall portfolio, depending on the investor’s risk appetite and time horizon, and the allocation can be staggered over 6-12 months. Chetanwala advises investors to limit the allocation to 10-15% of the debt fund portfolio only if they wish to invest in it. “Alternatively, you can consider investing in bank funds and PSUs and corporate bonds if you want to invest in mid-duration debt funds,” he says.