Sub-par returns in over half the schemes plague credit risk funds

10 out of 16 schemes have delivered below 6% returns in one year; Category AUM still a fraction of pre-pandemic level

Most debt funds, except for credit risk funds, have got their mojo back after the rate hikes. The yield-to-maturity (YTM) of these high-risk schemes is still 8 per cent or below —slightly better than the YTM (7-7.25 per cent) of safer fund categories like corporate bond funds.

Moreover, the slight rate differential ebbs if the fund management expenses or expense ratios are taken into consideration. 

Credit risk funds command around 1 per cent expense ratio, against a modest 0.3 per cent for corporate bond funds.

As a result, the net yield (YTM minus expense ratio) of both scheme categories is now nearly similar at around 7 per cent, leaving little incentive for investors to take higher risks.

YTM of debt schemes, which is the expected yield from underlying bonds, is a good indicator of future returns.

Credit risk funds have been spurned by investors since the pandemic breakout.  In 2020, these schemes witnessed net outflows of Rs 35,710 crore amid a string of downgrades and defaults in corporate paper. As a result, the assets under management (AUM) for this category plunged to Rs 28,500 crore in December 2020 (from Rs 62,000 crore in February 2020). As of August this year, credit risk funds had an AUM of Rs 26,260 crore — a fraction of pre-pandemic levels.

The assets have shrunk as returns have failed to keep pace with expectations.

According to the Value Research data, the three-year return of these schemes stand at 6.37 per cent compound annual growth rate, while the one-year return is 6.9 per cent, with 10 of the 16 schemes delivering sub-6 per cent.

Experts point towards multiple factors behind the poor performance of credit risk funds in the past few years. Among these are risk aversion among fund managers, unattractive spreads, and higher fund management fees.

“They seem very conscious about not hurting their brand. No one wants to be seen holding the papers of a company that has defaulted. They do fulfil the minimum investment criteria in lower-rated papers, but that is not enough. This is because even safer schemes like corporate bond funds invest a portion in lower-rated papers to augment returns,” says Rahul Jain, senior vice-president-research, International Money Matters.

The Securities and Exchange Board of India mandates credit risk funds to invest at least 65 per cent of their assets in papers rated ‘AA’ or below. Since this percentage is calculated by excluding the mandatory 10 per cent they have to hold in cash, the effective minimum investment in lower-rated papers is at just 58.5 per cent.

According to the Value Research data, the average holding of credit risk funds in ‘AA’ or below paper is even lower at 54.5 per cent (as of September 14).

Mumbai-based mutual fund (MF) distributor Rushabh Desai says even if credit risk funds were to offer a couple of percentage points higher than other debt schemes, the risk isn’t commensurate with returns.

“Debt is meant for capital preservation. There is no point in taking a high risk for 1 per cent or 2 per cent higher returns,” says Desai, also the founder of Rupee With Rushabh Investment Services.

Some believe this is not the end of the road for credit risk funds.

Suresh Soni, chief executive officer of Baroda BNP Paribas MF, believes that a lot is going in favour of credit risk funds and debt funds and returns will improve soon enough.

“The overall credit environment is not bad. The data shows that four companies are being upgraded for every downgrade. Corporate profitability is improving. These are good signs for the credit sector,” observes Soni.

Joydeep Sen, corporate trainer and author, says net YTM will improve in the future and credit risk funds can again become suitable for certain investors.

“The spread between government securities and corporate bonds sank to depths a few months ago. It has since improved, but is still lower than historical standards. Investors may await further improvement in spreads and net YTM to become more remunerative. There is no issue on the fundamental aspects,” adds Sen.