Your queries (mutual funds): always go for well-diversified credit risk funds and check the underlying holdings
What factors should I take into account when investing in credit risk funds?
Credit risk funds are a category of fixed income funds with a mandate to invest at least 65% of the assets in “AA” and lower rated corporate bonds. These funds aim to invest in lower rated (riskier) securities because they offer a higher return to investors (than well rated securities) to offset the risk of default and / or downgrade. These funds also present considerable liquidity risk due to the limited liquidity in the low rated segment of the Indian debt market. Credit risk funds can subject investors to steep declines, even putting their invested capital at risk, as has been seen in the recent past with a few credit risk funds even experiencing double-digit declines.
Although these funds offer a higher return than other categories of debt, you should be aware of the risks involved. Investors should limit the allocation to these funds to around 10-25% of their fixed income allocation, in accordance with their risk appetite. Rather than looking for high returns, investors should choose a fund with their risk appetite in mind.
When choosing a credit risk fund, look to invest in funds that are well diversified across issuers and sectors. Also examine the underlying holdings and their ratings in detail, so that the portfolio’s performance is not contributed by a few high-risk securities.
I am 45 years old and I can take risks for another five years. In equity funds, what type of fund should I look for with an investment horizon of 5 to 7 years?
Assuming a moderate risk profile given the short horizon of 5 to 7 years, invest with an allocation of 50% to equities and the remainder (50%) to bonds. As the investment horizon is moderate, most of the equity allocation should be devoted to large cap stocks (80 to 85%) because they are less risky than mid and small cap stocks. Although mid and small cap stocks have the potential to generate higher returns than large caps, they are more volatile and involve substantial risk. The allocation to the mid and small cap segment should be limited to around 15-20% of the equity allocation depending on your risk appetite.
The author is Director, Investment Advisory, Morningstar Investment Adviser (India). Send your questions to [email protected]