 "Amid varied risk levels, review portfolio before choosing credit risk fund")
Over the past year, credit risk funds (regular plans) have delivered a category average return of 7.45 per cent. These funds are required to allocate at least 65 per cent of their assets to corporate bonds carrying below-highest ratings.
Their fund managers often go down the credit quality curve in the quest for additional returns. Currently, there are fourteen funds in this category managing total assets of Rs 23,141.4 crore. Investors should consider not just past performance but also the inherent risks of these funds before investing in them.
High accruals, some capital gains
Accruals have contributed to returns over the past year.
“Accrual has been a good source of returns given that interest rate has been stagnant and yields have been rangebound,” says Manish Banthia, chief investment officer (CIO)-fixed income, ICICI Prudential Asset Management Company (AMC).
Vivek Ramakrishnan, fund manager, DSP Mutual Fund agrees.
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“Higher yielding bonds have given good carry (i.e., yields) -- 9 per cent plus in some of the AA and lower-rated non-banking financial companies (NBFCs) and 8 per cent plus in the case of corporates,” he says.
Some gains have also come from softening yields.
“In 2023, as interest rates headed lower, the government bonds portion of credit risk funds provided capital gains,” says Ramakrishnan.
Some of these funds recouped investments that were previously written off. “This contributed to their current double-digit returns,” says Vivek Banka, co-founder, Goalteller.
Positive drivers
Returns over the next 12 months may be driven largely by accruals.
“Given the positive rate environment, we believe accruals will remain a significant component of return, as spread assets provide a reasonable carry with a margin of safety,” says Banthia, fund manager.
Others expect capital gains to contribute.
“Our base case is that interest rates will decline in the coming year, providing scope for capital gains,” says Ramakrishnan.
Vijay Kuppa, chief executive officer, InCred Money, too, believes that if inflation remains around the Monetary Policy Committee's (MPC) target of 4 per cent for a sustained period, rate cuts could happen in the latter part of 2024-25, benefiting all debt funds, including credit risk funds.
The credit environment is expected to remain stable.
“Mutual funds have focused on maintaining portfolio liquidity and conducting thorough bottom-up credit analysis. They have also sharpened their focus on governance, which has reduced the likelihood of defaults,” says Ramakrishnan.
According to Banka, foreign institutional investor flows into Indian corporate bonds, driven by improvements in ratings, will positively affect the performance of these funds.
“Tactical investments in corporates with lower ratings but strong pedigrees could result in higher yields to maturity in these funds,” adds Banka.
Key risks
Inflation could take longer than expected to soften. “If geopolitical tensions intensify and crude oil prices exceed $100 per barrel, or if the monsoon is unfavourable, inflation could rise, reducing the likelihood of rate cuts,” says Banka.
“Credit spreads could widen if there is an increase in gross or net non-performing assets in the economy, affecting the performance of credit risk funds negatively,” says Kuppa.
Following the IL&FS debacle, many credit risk funds have become safer.
“However, as investors seek higher returns, some funds may lower their credit quality standards, leading to defaults and negative returns in the future,” says Banka.
Who should invest?
Only investors with a higher risk appetite should enter these funds.
“Maintain a horizon of at least one year, as most credit risk funds impose an exit load of up to 1 per cent for redemptions within that period,” says Kuppa.
Banka recommends that individuals in lower tax brackets, who can hold these funds for 12 to 24 months, should consider investing in them. With gains being taxed at the slab rate, the risk-return may not be advantageous for those in the highest brackets.
Investors should limit exposure to these funds to 5-10 per cent of their total debt fund allocation. Those with a low risk appetite may avoid them entirely. Banka advises against investing in funds within this category that have high expense ratios and portfolio durations exceeding three years. Finally, before investing, review a fund’s bond holdings to understand its risk level.