Credit risk funds: A high return scenario ahead
Authored by Sandip Raichura, CEO and Executive Director, Prabhudas Lilladher Pvt Ltd
Post the Templeton and ILFS crises, there was a lot of risk aversion towards taking any sort of risk in portfolios – whether via equity or debt. However, a heady brew of events over the next few years has now created a Goldilocks situation where midcaps /smallcaps/SMEs in equities and high-yield debt via AIFs have huge demand and are likely to remain so for the next few years barring episodic volatility. In fact, the speed at which Cat 2 AIFs (Private Debt) funds have grown is testimony to the story of India ahead as well as the kind of returns that debt can generate!
At the same time, however, retail investors – who do not have corpuses of above Rs 1 crore that debt AIFs require, have been still staying away from credit funds or debt or moving in but very slowly. Our view is that retail investors should make the most of the situation ahead by diversifying into long-term Gilt funds apart from taking small exposures into a hitherto ignored category, Credit Risk Mutual funds.
What are credit risk mutual funds?
A Credit risk mutual fund is a debt-oriented mutual fund that invests in lower-rated debt instruments (SEBI has issued guidelines which require that a mutual fund must invest at least 65 per cent of its corpus into debt instruments having with a rating below AA+ to qualify as a credit risk mutual fund) with the intent to maximise returns. It aims to generate higher returns by investing in securities that pay a higher yield than high-rated funds. However, to compensate for the risk taken, the coupon rates on these securities tend to be high. Thus making the credit risk fund’s returns higher than other funds but also raising the risk profile at the same time.
The main focus of credit risk funds is to allocate their investments in debt securities issued by entities with lower credit ratings, including non-banking financial companies (NBFCs), corporate bonds with lower ratings, and sometimes distressed assets.
Why invest Now
Credit risk funds require a stable or favourable credit environment to outperform the other Debt Funds. This is exactly what is happening now with international GDP rates beginning to improve (barring the USA), the dollar weakening (Favorable for emerging market flows) and of course, inflation possibly overcoming at least supply-side shocks post covid.
This, apart from the fact that Indian banks are flush with cash, apart from AIFs that are willing to help distressed or restructuring entities with money collected from HNIs and funds, means that the wider landscape for industrial and services activity has become much more sustainable than earlier. And therefore there is a likelihood that the general rating profile of corporates would be better as time moves forward. Remember that bond ratings improving mean not only high current yields but also capital gains as such securities come into demand.
Who Are These Funds For
By assuming the additional risk associated with investing in lower-rated debt instruments, these funds offer an opportunity to earn enhanced yields compared to traditional debt funds and are a good option for investors with at least a 3-year horizon.
You must consider investing in these funds if you have a medium-to-high risk tolerance and want to invest in debt funds as a means to diversify portfolios as well as prepare for the potential scenario ahead. Since these funds invest mostly in corporate bonds rated AA and below, they essentially carry higher risk. At the same time, the return potential is higher when compared to liquid and overnight funds.
Disclaimer: Investors should carefully evaluate their risk tolerance, and investment objectives, and consult with financial advisors before considering credit risk funds as part of their investment portfolio.