Investing in credit risk funds: A sensible move or not?

But rather than quickly parking hard earned money to earn higher yields it is crucial to evaluate the factors that augured well for the credit risk funds. One of the prominent one is...

Investing in credit risk funds: A sensible move or not?

Credit risk funds are once again in spotlight. After a disappointing phase between 2018 till early 2020 owing to series of defaults and downgrades; the credit risk funds have made a strong comeback. The average category returns of these funds stood at 18% for the one-year period ended April 29, 2022. The credit risk funds have managed to clock double digit returns in the recent times thanks to RBI’s several measures to infuse credit to stressed sectors and revival in the economic activity which in turn has helped in the enhancement of the debt market liquidity and credit profile of many issuers. At this juncture, the obvious question will be is it wise to invest in credit risk funds for higher yields? What to look out before investing? Let’s find out the answer to these questions.

Factors contributing to encouraging performance of the credit risk funds in the recent times

Performance is one of the key factors of attraction when it comes to mutual fund investing. Whenever a mutual fund category performs well it starts making headlines and investors are often tempted to jump the bandwagon to harness the upside. Similar has been case with the credit risk funds which is in spotlight once again after dismal show few years back. But rather than quickly parking hard earned money to earn higher yields it is crucial to evaluate the factors that augured well for the credit risk funds. One of the prominent one is the several regulatory moves announced by the Securities and Exchange Board of India (SEBI) given the massive volatility, downgrade and defaults which has impacted credit risk funds and also other debt-oriented categories.  Firstly, SEBI mandated credit risk funds to invest 65% of their investment portfolio in low rated debt securities typically AA and below.  Secondly, to enhance the liquidity management framework of the debt-oriented funds, SEBI asked these funds to invest at least 10% of their net assets in liquid securities such as cash, government securities, repo on government securities and T-bills. The capital market regulator directed all open-ended debt schemes (except for the overnight scheme) to conduct stress testing and a mutual fund house shall not invest more than 10% in Additional Tier I bonds and Tier 2 bonds issued by the single issuer. The performance of the credit risk funds have also got a boost from the improved credit environment in the economy.

Investors with higher risk appetite keen on earning higher yields amid the low-interest rate environment can invest a small portion but only after careful evaluation of the fund performance as these funds are highly risky.  For those investors belonging to higher tax slab of 30% long term investment in credit risk funds can help to reduce the tax outgo as the long-term capital gains is taxed (LTCG) is 20% with indexation benefit. However, before investing assess the underlying risk factors and suitability aspect.

Risk factors, selection and suitability of the credit risk funds

Credit risk funds aims to generate returns by investing in the low rated papers. Such instruments pay higher yields but the investment carries higher risk of default and downgrade. These funds also carry liquidity risk. In event of the default or a downgrade a fund manager may find it difficult to exit the investment it had made which could impact the funds’ performance. Hence, selection of the credit risk funds calls for the due diligence of the several aspects such as:

  • Check fund manager and its team overall expertise and experience in the debt portfolio management
  • Evaluate the credit quality of the portfolio i.e., composition of the AAA, AA, A rated papers, portfolio’s yield to maturity, whether the portfolio concentration is high or is it well diversified across issuers and securities
  • Analyze the past performance of the fund in terms of returns across different cycles, corpus of the fund, track record of the fund house, expense ratio etc.

Post evaluation of the aforementioned aspects, investment in the credit risk funds is best suited to savvy investors with higher risk appetite who can tolerate the market volatility. It is prudent to invest only smaller portion of the overall investment portfolio for the investment horizon of 3 to 5 years. Don’t invest money for the short term with a view to make quick bucks as these funds are highly risky. Adopt a disciplined and cautious approach to investing.