Upbeat outlook amid stable credit environment, high portfolio yield

Take moderate exposure to these funds, given the potential for defaults and downgrades in their lower-rated portfolios

Among debt funds, credit risk funds have emerged as the best-performing category with an average return of 7.67 per cent over the past year.

“Credit risk funds have outperformed other fixed-income categories due to their higher accrual, as rates have largely remained range-bound this year,” says Anurag Mittal, head of fixed income, UTI Asset Management Company (AMC).

“Also, certain stronger issuers within the credit category have witnessed spread compression as they have deleveraged their balance sheets. Furthermore, a few funds have seen recovery from stress cases, which has boosted their near-term performance,” Mittal adds.

According to Joydeep Sen, corporate trainer (debt) and author, “Credit risk funds have not seen any fresh credit accidents over the past three years. Their higher accrual is coming into play.”

Higher risk, higher returns

Credit risk funds invest in lower-rated bonds that offer higher yields.

“They offer the potential for higher returns compared to traditional fixed-income investments since they invest a minimum of 65 per cent in corporate bonds rated AA and below, which offer relatively higher yields,” says Sirshendu Basu, head-products, Bandhan AMC.

However, the lower credit ratings of a large portion of their bond holdings connote higher credit risk.

“Their main disadvantage is the increased risk associated with lower-rated securities. These funds can be susceptible to defaults or downgrades, impacting the fund’s value. Additionally, they may be more sensitive to economic downturns, making them riskier in volatile market conditions,” says Basu.

Another risk is the illiquid nature of lower-rated bonds. If the bond markets are depressed and investors are wary of investing in bonds, then these bonds may not find buyers at a fair price. That can put pressure on the managers of these funds, who may find it difficult to honour redemptions in stressed times.

Most fund managers today run diversified portfolios spread across issuers and sectors to contain credit risk.

Positive outlook

Experts say that credit risk funds would be good investment bets unless some unforeseen credit event rocks the debt market.

“The outlook for these funds is positive. The credit environment is better now, with rating agencies upgrading more companies than they are downgrading. I expect the market to be more or less stable. A credit accident could impact these funds, but the possibility of such an event is low currently,” says Sen.

Mittal agrees. “In the absence of credit events, credit risk funds can outperform funds having similar duration and those having better credit quality due to their higher accrual and credit spread compression,” he says.

“In the near term, the outlook for credit funds remains constructive as policy rates have likely peaked while demand for higher-yielding securities could increase due to changes in debt fund taxation,” Sen says.

To obtain a ballpark figure of the returns from these funds, deduct the scheme’s expense ratio from its portfolio yield to maturity (YTM). For example, if a scheme has a portfolio YTM of 8.49 per cent and an expense ratio of 1.57 per cent, the expected return would be around 6.92 per cent.

Check your risk appetite

Credit risk funds make sense for investors with high-risk appetite.

“Investors should carefully assess their risk tolerance and investment goals to determine if a credit risk fund aligns with their financial strategy,” says Basu. Mittal says those looking to mitigate downside risk should avoid this category.

Go for the long haul

These funds require at least a medium-term horizon.

“Those with a longer investment horizon of three years and above, who can hold onto their investments through market cycles and weather periodic volatility, should look at these funds. Remember that credit risk funds can take time to recover from downturns. Since it would be a satellite allocation in one’s portfolio, one may consider an allocation of 10 to 20 per cent of the debt fund portfolio in this category,” says Basu.

According to Sen, “The ideal holding period in any debt fund is the fund’s portfolio maturity or maybe a little lesser. If a credit risk fund’s portfolio maturity is four years, an investor should hold it for four years, or at least three years.”