However, a quick glance at the performance charts reveals a muddled picture that is not particularly flattering for credit risk funds. Over the past year, liquid funds have fetched an average return of 6.5%, even as credit risk funds have clocked 7%. This is too short a period to allow for comparison of performance. Over longer time frames, credit risk funds have flexed their muscles, albeit inconsistently. Over the past three years, for instance, credit risk funds have outperformed sharply, delivering an annualised return of 9.8%, compared to liquid funds’ 4.5%. During this period, the credit profile of Indian companies improved sharply, with credit rating upgrades outnumbering the downgrades.
Alekh Yadav, Head of Investment Products, Sanctum Wealth, points out, “Several funds, which had earlier written down underlying bond values amid defaults and downgrades, marked up the prices as credit profile improved. This gave a boost to fund NAVs.” The credit spreads of AA and lower credit rated instruments over AAA and sovereign bonds also narrowed significantly over this time frame. This reflects in the outperformance of credit risk funds in the past three years.
However, this gap is not as evident over five- and 10-year time horizons. In fact, over the past five years, liquid funds have been on a par with credit risk funds; both categories have averaged around 5%. This phase covers the initial turbulence unleashed after the IL&FS default in 2018. Several funds from the credit risk space saw a sharp erosion in NAVs amid a spate of defaults and downgrades in underlying bonds. To that extent, the no-show by credit risk funds in this period was expected. Dhawal Dalal, CIO, Fixed Income, Edelweiss Mutual Fund, observes, “The crisis of confidence among investors after the IL&FS issue has resulted in the subdued showing by credit risk funds over the past five years. Some credit funds had to create segregated portfolios for the affected securities.”
However, even over 10 years, liquid funds have clocked 6.7%, not lagging far behind credit risk funds’ 7.5%. This runs contrary to expectations that taking credit risks can deliver far superior rewards. Experts maintain that for all their hype, credit risk funds have punched below their weight. Investors have not been adequately rewarded for the risk taken. Pankaj Pathak, Fund Manager, Fixed Income, Quantum Mutual Fund, has been cautioning investors against pursuing credit risk funds for many years. “Credit risk funds in India have structural flaws. Poor liquidity in the credit space is the biggest drawback and this often plays out in the returns,” he says. Running a portfolio of illiquid bonds in an open-ended structure poses challenges. It is also difficult for the fund manager to churn the portfolio even when his own view on underlying holdings changes.
With credit risk funds, the risks are more pronounced when the economy is in full swing. Investors tend to get complacent exactly at this time, confusing the economic growth cycle with favourable credit cycle. Credit events have often been a lead indicator of trouble brewing within the economy. Even the days leading up to the IL&FS blowout were marked by clear skies, giving no indication of the gathering clouds. “Investors often underestimate the risks in this category. Defaults and liquidity problems materialise only once every few years, but when they do, it tends to wipe out a chunk of investors’ capital,” says Pathak.Lacklustre show by credit risk funds
Modest return gap over safer debt funds has not compensated for higher risk.
While credit risk funds have put on a good show over the past three years, experts suggest staying away for now. “Credit spreads for assets have been tightening due to the rise in sovereign yields,” says Dalal. Besides, with stringent rules introduced after the IL&FS episode to ensure better liquidity and enhanced safety, credit risk funds no longer offer the same bang for the buck. Yadav asserts, “Most credit risk funds have now moderated their aggressive stance, not venturing too far beyond AA rated bonds. Subsequently, yield to maturity (YTM) for this segment has softened. With expense ratios still elevated, the net YTM on offer is not compelling relative to safer debt fund categories.” At 8.1%, the current YTM for credit risk funds seems attractive compared to liquid funds’ 6.8%, but after factoring in expense ratio, the net YTM for both categories is 6.5%.
Experts maintain that while the credit risk space carries a lot of potential, mutual funds do not offer the right avenue for exploiting it. “Mutual funds are not the best vehicle to play credit market owing to the stringent rules in this category. The true potential of high credit can be tapped through alternate investment funds (AIF), which possess greater flexibility and have a bigger canvas to play with,” says another industry official. Yadav points out that structured credit funds in the AIF space are the flavour of the town. With their closedended structure, fund managers don’t worry about illiquidity and can take higher credit risk via A and BB rated instruments, offering high potential for alpha. This, however, remains the exclusive domain of HNIs. For retail investors, the credit space is no longer as lucrative.
