Credit risk

Is Now a Good Time to Invest in Credit Risk Funds?

As this report indicates, credit risk funds may offer better returns because the spreads between AAA and AA are still attractive, but not as attractive as they were in the aftermath of the Franklin Templeton fiasco.

On October 5, 2021, Moody’s changed the outlook for India’s sovereign ratings from negative to stable and maintained its rating at Baa3 for India’s foreign currency, long-term issuer ratings in local currency and the rating. senior unsecured in local currency. The change in perspective was due to their belief that the downside risks of a negative feedback between the real economy and the financial system are decreasing. As previously anticipated by the rating agency, with capital buffers and greater liquidity, banks and non-bank financial institutions pose much lower risk to the sovereign. Nonetheless, another rating agency, Fitch, reaffirmed its BBB sovereign ratings on India, which is the lowest investment rating compared to India’s sovereign rating. Fitch Ratings maintained its negative outlook as it believes India has high government debt, a weak financial sector and some lagging structural issues.

Fitch Ratings has warned that India could suffer a downgrade if it fails to reduce the ratio of public debt to GDP. Structurally weaker real GDP growth prospects due to continued weakness in the financial sector or lack of reform implementation could further weigh on the debt trajectory. That said, India is experiencing a rapid economic recovery from the pandemic. In addition, the pressures on the financial sector are also easing and even the risks are decreasing. Credit institutions expect demand for business loans to rebound by the end of FY22. Indeed, in order to meet the growing demand for goods and services in a context of resumption of economic activities, companies would look at capital expenditure.

Improve the economy and credit risk funds

For a mutual fund investor who wants to invest in debt funds, improving economic growth presents a good opportunity to gain exposure to credit risk funds. Last year, due to erratic credit events and some headwinds in the economy, credit risk funds began to feel the heat long before the pandemic. Credit risk funds are a type of debt-focused mutual fund that invests in securities with a lower credit rating, thus giving them the name of “credit risk” funds. Credit risk funds in India are mandated to allocate at least 65 percent of their portfolios to debt securities rated below “AA”.

Investors began to fall out of this category when Franklin Templeton closed its six debt financing programs in April 2020. As of October 2021, the fund house had distributed around 88% (Rs 23,999 crore) to investors out of a total of Rs. 27,333 crore under management (AUM) from the six closed plans.

As can be seen, assets under management of credit risk funds fell drastically after the Franklin Templeton fiasco. Even if assets under management remained stable there, net inflows rose from February 2021 and in May 2021 it went into positive territory. This shows that interest is gradually growing in credit risk funds. Institutional investors, who are seen as smarter than retail investors and dominate debt-focused programs (nearly 63% of assets under management), have increased their investments in these funds, which is reflected in the graph below. -joint. So the assets under management and the increase in net inflows to credit risk funds give a good idea of ​​what to expect going forward. In addition, what also favors credit risk funds is better credit taking. While there is no direct relationship between rising credit and the performance of credit risk funds, better credit growth signals good economic recovery and lower risk on lower rated papers. In FY22, credit underwriting improved, with non-food credit growth rising to 6.8% year-over-year on September 24, 2021, from 5.1% a year ago. This is more evident from the graph below.

Credit growth among public sector banks remained modest, while there was a slight increase in the case of private sector banks which provided the bulk (56.7%) of additional credit extended by banks. regular commercial banks (SCB) on an annual basis as of September 24. , 2021. Thanks to a favorable monsoon and measures to support the agricultural sector, even public sector banks recorded year-on-year credit growth in August 2021.

It is quite evident from the charts above that bank credit to the industry has started to improve and can see a good improvement on a year-over-year basis. Credit to infrastructure – which accounts for around 38% of industrial credit – has also improved, driven by credit to roads and airports. The main driver of overall industry credit growth has been infrastructure, followed by textiles. Credit growth to the service sector slowed to 3.5% in August 2021, from 10.9% in the same month last year. This can be largely attributed to the slowdown in credit to NBFCs which have raised resources primarily in the money and debt markets.

The chart above clearly shows that overall domestic credit growth has improved after hitting a 10-year low of 5.35% in May 2021. Credit growth has yet to reach pre-pandemic levels. . However, if we look at the recovery in economic activity, it looks like credit growth is going to be robust in the near future. The second factor that gives an idea of ​​the performance of these funds is the weighted credit to debt ratio. The credit ratio, calculated as the number of upgrades or downgrades, maintained its ascending position during the first half of FY22. According to CRISIL, there were 488 upgrades and 165 downgrades for the first half of FY22. When we calculate the debt weighting ratio, it shows the debt weighted credit ratio.

Historically, we have seen that there is a positive relationship between the debt-weighted credit ratio and the returns generated by credit risk funds. During the years 2014 and 2016 we saw credit risk funds generate double digit returns and it is no coincidence that these two years we have seen the debt weighted credit ratio s ‘to improve. In FY17, we found that although the credit ratio remained stable, the debt-weighted credit ratio was at its highest level in five years. Likewise in 2014, we saw a marked improvement in the debt-weighted credit ratio, from less than 0.3 to around 0.5.

Raising the credit ratio means lower risk and therefore higher return as the yield decreases and the value of the bond increases. At the end of S1FY22, the debt-weighted credit ratio is greater than 2, which is a positive sign for such funds. The annual returns of this category of funds already give an idea of ​​the returns to be expected from these funds. The following table shows the returns by calendar year for credit risk funds:

On an annual basis, credit risk funds averaged 8.56% return, but there were funds such as UTI Credit Risk Fund, Baroda Credit Risk Fund, IDBI Credit Risk Fund, Franklin India Credit Risk Fund. and Nippon India Credit Risk Fund which gave double – number returns of 20.92 percent, 18.71 percent, 15.55 percent, 12.82 percent and 12.80 percent, respectively.

Should you invest in these funds?

To conclude, we believe that there is still room for credit risk funds to provide better returns as the spreads between AAA and AA are still attractive, but not as attractive as they were the day after. Franklin Templeton fiasco. We believe that he is an aggressive risk-taking investor who should not invest more than 10 percent of his debt portfolio in credit risk funds. Also, it should be included in the satellite wallet and not be part of your main wallet. In addition, credit risk funds should be actively managed depending on the credit situation and the overall performance of businesses and the economy. So if you understand these nuances, you can still invest in such funds as part of your tactical investing strategy.

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