Debt funds: Should you bet on credit risk funds?

A search for higher yield amid the low-interest rate environment, attractive spreads post the Franklin Templeton episode and abundant systemic liquidity have led individuals to invest in credit risk funds. After Franklin Templeton shut down six debt schemes investing in lower credit rated paper and high redemption pressure in April 2020 and concerns over downgrades and defaults of issues, investors redeemed close to Rs 36,000 crore from this category in 2020.

Last year, the category witnessed an inflow of Rs 918 crore following a decline in risk aversion on expectations of robust corporate earnings amid recovery in economic activity from the impact of the Covid-19 pandemic. However, this year till March, credit risk category has witnessed an outflow of Rs 984 crore.

Should you invest?

So, should retail investors take some risks and invest in these debt funds? Dhaval Kapadia, director, Investment Advisory, Morningstar Investment Adviser (India), says, currently, the additional yield (spread) offered by credit risk funds over shorter duration funds (Corporate bond, Banking & PSU Debt, Short Duration) is significantly lower compared to first half of CY2020. “As a result, keeping the risk-reward in perspective allocation to credit risk funds should be restricted, and one can look to build allocation in a staggered manner when valuations turn more favourable (spreads widen from current levels),” he says.
Pankaj Pathak, fund manager, Fixed Income, Quantum AMC advises retail investors to stay away from credit risk funds. “In credit risk funds, the risk reward dynamics is not in favour of investors. If everything goes right, investors may get 1%-2% extra return. But there is a risk of losing a large chunk of one’s portfolio if something goes bad,” he says.

What to look out for
Credit risk funds carry a higher risk among debt funds as these may invest some part of their portfolio in low rated companies as well. Hence, those investors who want to generate additional returns along with some risk opt for credit risk funds. Moreover, liquidity is a big problem as the secondary market for lower rated debt securities has not yet developed in India, which makes portfolio churning or at times, even meeting redemptions extremely challenging.

While deciding upon a credit risk fund, look at funds which are well-diversified across issuers and sectors. Harshad Chetanwala, co-founder, MyWealthGrowth.com, says the companies in which the fund is investing define the credit risk these funds take to generate additional returns. “Along with quality, you can also look at the diversification of the portfolio and size of the fund at the time of investing. Keep your debt fund portfolio also diversified,” he says.

Investors should look at the past performance (returns, drawdowns) of the fund and analyse any past credit rating downgrades and upgrades, to take cues about the robustness of the investment process followed. Also, consider the stability, tenor and experience of the fund management team. Kapadia advises to diversify the credit risk exposure across more than one fund, to restrict exposure to the bets and/or style of a single manager. “Also, look out for the expense ratio and high exit loads that a few funds in this category charge,” he says.

Quantum of allocation
The allocation to such funds could be 10-15% of the overall portfolio, depending on the risk-appetite and time-horizon of the investor and the allocation can be staggered over 6-12 months. Chetanwala advises investors to restrict the allocation to 10-15% of the debt funds portfolio only if they want to invest in it. “Else, you can consider investing in banking and PSU and corporate bond funds if you wish to invest in medium duration debt funds,” he says.