Is it a good time to Invest in Credit Risk Funds?

Last year has been challenging for investors, particularly those who had invested in debt mutual funds. A series of downgrades and defaults took a toll on the performance of these funds and many investors witnessed a significant drop in their investment returns from these investments. The generally mood of the investors is one of gloom and pessimism and most of the investors are seeking investments in debt products with lesser risk. Many have become completely risk averse altogether!

In my experience, the best investment opportunities are generally found in such environments and I decided to explore a category of funds termed Credit Risk Funds, which have been completely out of favour with investors. As per SEBI categorisation of mutual funds, Credit Risk funds need to invest a minimum of 65% of their investments in corporate bonds with investment rating below the highest grade. (Read about CRISIL Credit Ratings scale)

Is it a good time to Invest in Credit Risk Funds now?

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There are several reasons why it may be worth considering investing in Credit Risk Funds at this point in time.

First, the interest rates have dropped significantly for risk free assets. The 10 year G-Sec yied has dropped from over 8.0% in September 2018 to 6.6% now (See chart below). The Reserve Bank of India has been continuously dropping interest rates and after the recent monetary policy announcement, the Repo Rate is at a 9 year low of 5.15%. The Fixed Deposit Rate offered by SBI on a 3 year deposit stands at 6.25% p.a. This clearly shows that the investors are paying a huge price for safer assets. 

Second, the credit spreads have widened and this has resulted in borrowers having to pay a much higher interest rate in case the borrower is perceived as higher risk ( as in case of NBFCs currently). The chart below shows that NBFCs in India are currently paying a much higher interest rate than government bonds.

Third, mutual funds have strengthened their risk assessment framework so that the chances of such problems arising in the future are minimised. After the IL&FS and DHFL fiasco, most mutual fund companies have learnt their lessons and are much more vigilant as compared to before.

Fourth, the regulator too has imposed various risk mitigation measures and has reduced the proportion of investments that can be made by debt mutual funds in to a single sector.

 

How should an Investor take advantage of this opportunity?

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I have articulated the key advantages of investing in Credit Risk funds at this point in time. But Credit Risk funds by their very nature carry a high level of risk and the same needs to be managed effectively.

Invest with a 3 year plus horizon: The defaults and downgrades lead to a drop in NAV of the Credit Risk Funds and hence investing with a shorter term horizon can be risky for investors. The minimum horizon that investors must have to invest in such funds is at least 3 years. In fact, investments held for over three years in debt funds are also more tax efficient as long term capital gains are taxed at 20% (after adjusting for indexation).

Diversify: Investors should spread their investments across 2 to 3 Credit Risk Funds. This will ensure that their exposure to a particular debt security is reduced.

Provide for any financial requirements that are needed over the next 3 years by investing in short term debt funds with a high credit quality. It is important that investors leave their investments in credit risk funds untouched for a period of at least 3 years in order to get optimal returns.

Risk Appetite: Credit Risk Funds will remain volatile and investors should not panic and should be able to withstand the short-term volatility. These funds are only for those with a higher risk appetite. 

Conclusion

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In conclusion, I would like to quote from the Fixed Income Update – September 2019 of ICICI Prudential AMC.

“Our framework signals that accrual schemes have moved into the ‘buy’ territory with attractive valuations (spread between repo rate), reduced flows, and negative sentiments (NBFC liquidity crunch). The risk-reward benefit has turned favourable and it’s a good time to earn the carry with high credit spreads available in the corporate bond space. Having said that, we remain cognizant of managing the liquidity, concentration, credit and duration in our accrual portfolios to provide better risk-adjusted returns”