Should you invest in credit risk MFs now? | Economic Times

Credit risk funds are currently sitting on top of the performance chart of debt funds. Yes, the same ill-behaved bunch that was floundering at the bottom of the chart a year ago. These have clocked a healthy 9% average returns over past one year in sharp contrast to the miserable –3.7% yielded back then. Does this stellar show mark a turnaround in the much-derided category?The travails of credit risk funds in recent years are well known. A string of issuer defaults and downgrades sunk several funds that consciously took higher exposure to lower quality issuers. The hunt for higher yields backfired badly as credit events surfaced one after the other. The funds took sharp NAV hits, wiping out multiple years’ worth of returns in many cases. These funds were largely responsible for giving birth to the concept of segregated portfolios—also known as side-pocketing—in India. This refers to the carving out of bad assets from the cleaner portfolio into a separate fund in order to ring-fence the former. So, does recent performance suggest that the worst is over for credit risk funds? There are several reasons behind this improved show. 83866849Part of the ‘turnaround’ can be attributed to the low base effect of last year. Much of the rotten bonds had either been carved out or written down to reflect actual worth by this time last year. Even some of the quality bonds had seen dip in value owing to weak market conditions. As a result, fund NAVs had seen sharp corrections. The returns that you see today are on this lower initial value. Owing to the segregation of bad assets, returns over this time period have also captured much cleaner portfolios. However, performance of the segregated portfolios is not captured in the fund returns, and therefore in category performance.Further, these funds were running higher yields at this time last year, which have been captured in today’s NAV. Bonds rated AA and below had seen their yields flare up to 9-10% or higher amid tight liquidity conditions and beaten down prices. “Funds benefited from the higher accruals prevailing a year ago, which is showing up in the return profile today,” points out Vidya Bala, Head – Research, Primeinvestor.in. By contrast, the yield to maturity (YTM) on these funds is much lower today at 6-7% or even less. The fund returns in the near term will also reflect these low yields. Some of the most badly affected funds have particularly made the most of these gains. BOI AXA Credit Risk, Baroda Credit Risk, Aditya Birla Sun Life Credit Risk, Nippon India Credit Risk and IDBI Credit Risk have emerged among the top performers over the past year. Franklin India Credit Risk—among the six suspended debt funds of Franklin Templeton—is also among the table toppers. Apart from the higher accrual, these funds have also benefited from appreciation in bond prices pushed down earlier. “The sheer magnitude of the initial shock justifiably triggered the need for safety in investments for many. As it turned out, however, the nature of the shock and the subsequent behaviour of lenders and companies ended up substantially rewarding the risk taker during that phase,” notes Suyash Choudhary, Head – Fixed Income, IDFC AMC, while explaining the pickup in lower credit papers.So, what should investors make of credit risk funds in their current avatar? Improved returns can often mask underlying realities. Heavy redemptions over the past one year have left some affected funds with skeletal, cash-heavy portfolios running concentrated exposures in a few names. PGIM India Credit Risk, DSP Credit Risk, BOI AXA Credit Risk and IDBI Credit Risk are some examples. Yet, some of the troubled lot have revisited risk practices after the hit to NAV and perception. A few have cut back substantially on exposure to poor quality and unrated bonds and moved higher up the credit ladder. The funds’ aggregate exposure to bonds rated below AA (including unrated) has reduced from 26% a year ago to 11% now. “Credit risk funds have been scaling down their risk profile gradually to run a much cleaner portfolio today,” observes Bala. Some funds have taken conscious decision to shun concentrated exposure and focus only on names with cash flow visibility. This is apart from the handful of funds which were already running more prudent risk practices like ICICI Prudential Credit Risk, HDFC Credit Risk, Kotak Credit Risk, SBI Credit Risk and IDFC Credit Risk, to name a few. While credit risk funds today don a cleaner look compared to a year ago, investors must remain watchful for any deterioration in risk profile. Do not be tempted purely by the past one year’s return. Recent corrective steps by funds and moderate yields will put a lid on returns going forward. Credit spreads (yield differential of lower rated bonds over highest credit quality) have narrowed significantly, leaving limited return potential relative to risk. “This backdrop calls for greater credit consciousness and a heightened awareness of how much reward one is getting versus risk taken,” opines Choudhary. Only those who have sufficient risk appetite should consider these funds. The choice of funds is also critical in this space—ascertain the portfolio composition not just for credit quality but also extent of diversification.