Credit risk funds suit well for risk-takers

Debt mutual funds (MF) are those which predominantly invest in debt instruments of various types that include from money market instruments like treasury bills (T-bills) to corporate bonds to commercial paper to Government securities (G-secs) or Gilts.

Each of the instruments carry a different risk and thus the return associated with them. The choice of investment should always be in-line with the risk appetite of an individual and time horizon for the investment.

Credit risk funds are a type of debt MF where the portfolio predominantly (at least 65 per cent) invests in instruments rated AA or lower.

One has to understand that lower the rating of these instruments, higher is the risk which means that the ability of the borrower to service the loan is doubtful.

While any rating upgrade could possibly provide a higher capital gains (when divested) could also impact the overall portfolio and it's return during a downgrade.

Of course, the lower rating is also subject to higher yields and thus could add higher returns to the portfolio.

Rating of these bonds are done by independent agencies which upon checking their credentials that include the financial status, the impact on the business of the borrower with the changing economic/political/regulatory environment and the future cash flows of the borrower (the capacity to repay or service the loan).

They not only rate at the beginning of the issuance of bonds but periodically check and report to the regulator about the continuity of the rating or not.

The performance of these funds, though, depends on the diversification or lack of it i.e. the exposure to various instruments and the limit of concentration to a particular instrument.

In the last couple of years, especially, post the IL&FS debacle and the onset of Non-Banking Financial Companies (NBFC) turmoil, there were many bonds which were downgraded drastically.

In some cases, to a default (D-rating) which almost brings the exposure to zero, adversely impacting the investment returns.

During the current crisis, the overall category has underperformed and have given paltry returns. This is purely due to the higher concentration of defaulted instruments, an increased or skewed allocation towards a particular group in their portfolios thus pulling the entire category downwards.

The idea of these funds is to give three – four per cent higher returns than those of the fixed deposits.

Another argument is that this performance compares with that of the conservative hybrid funds where the equity exposure could be as high as 25 per cent of the portfolio.

So, would these portfolios reflect the volatility of equity? For instance, the success of IDFC Credit risk fund and ICICI Pru credit risk fund could be ascribed to their greater diversification and judicious asset allocation.

Within this category these funds have performed well by generating returns to the tune of 9 per cent and upwards.

The general comprehension of public is that the debt funds are safe or of low or negligible volatility.

The reality is quiet contrary where the bond prices are influenced by multiple exogenous factors, most of which are out of our control.

Despite the recent past performance, the divergence of the highly rated bonds i.e. of AAA with that of the lower rated bonds have broadened, making it attractive for an exposure to the portfolios.

However, these funds are not a replacement to the existing bank fixed deposits at least not for all types of investors.

Investors should also be aware that a highly rated bonds i.e. AAA or G-Secs have daily volatility though the liquidity is high and are safe (relatively) while on the lower rated funds, the yield is higher but possibly come up with a nasty surprise of a default, despite the increased regulatory framework.

For investors who can't stomach these variables, are recommended to stick with traditional bank deposits but for those seeking higher return but at an increased risk could consider these funds.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)