Credit risk

How do you choose a good credit risk fund for investing?

The worst phase of defaults in Indian debt mutual fund history began in September 2018. A quasi-PSU, rated AAA, went from AAA to D in less than two months. Since then, throughout 2019 and into early 2020, there have been several flaws. In the debt mutual fund space, the most affected category was obviously credit risk funds, as they were the most exposed to instruments rated less than AAA. Now that it has been three years, it is worth looking back at the impact of the multiple flaws.

Rather than intellectualizing and philosophizing about impact, let’s take a simple and practical approach. The performance of this fund category, three years to date, will show us the net impact.

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The conventional approach is to take the category average. Net of all defaults in the fund portfolio of this set of peers, the three-year average annualized return through September 9, 2021 is 1.82% for the regular option and 2.64% for the direct option. Not very encouraging, it seems, as investors have obtained sub-optimal returns. However, to be kept in mind, this includes the worst flaw phase in history.

Now let’s take another perspective. The larger funds in the category performed better and the most affected funds are relatively smaller. That is, the impact on investors from a macroeconomic point of view is not as bad as it seems from the simple average. Taking the corpus size as the weight, the weighted average over the three years until September 9, 2021 is 7.66% in the regular option and 8.38% in the direct option. There is a remarkable difference between the simple average and the weighted average. If the larger funds that coped better with higher defaults and the smaller ones that suffered more fared better, the overall impact on investors would have been much worse.

To take a few specific cases, the HDFC Credit Risk Debt Fund with a body size of over Rs 8,000 crore, generated returns of 9.28% and 9.81%. The ICICI Prudential Credit Risk Fund with a body size of almost Rs 8,000 crore, generated returns of 8.82% and 9.56%. These two funds are the main contributors to increase the average from 1.82% / 2.64% to 7.66% / 8.38%. On the other hand, the most affected fund, BOI AXA Credit Risk Fund with returns of -31.98% and -31.8%, has a corpus size of less than Rs 100 crore. To this extent, the impact on investors was limited.

If you are to have a credit risk fund review you should look at:

  • YTM Wallet: A higher YTM has inherent appeal. However, if the YTM is significantly higher than the peer group, it means a relatively higher level of credit risk.
  • Breakdown of portfolio credit ratings: composition in terms of AAA, AA, A, etc. Obviously, the higher the score, the better.
  • Portfolio Concentration: The more concentrated the portfolio, the worse it is. After IL&FS and DHFL, we know that even an AAA entity can fail. Although the SEBI limit is 10% per issuer, within the limit, if an AMC maintains a more diversified portfolio, the better. An equity fund portfolio with 100 papers is over-diversified, but there is no over-diversification in the debt portfolio.
  • The skin in the game: If the AMC invests itself in its Credit Risk Fund, it shows the level of confidence.
  • AMC process followed and history.

(The writer is a business trainer and author.)


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