Should investors invest in credit risk funds?

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The data as per the value research shows that the Credit Risk Fund (CRF) has given a return of 7.85% over one year as of July 2, 2021. This debt fund category invests primarily in bonds with a lower-than-investment grade rating with the goal of generating alpha, i.e., at least 65% of total assets are invested in corporate bonds (Investment in below rated highest instruments).

Since last year, this category has made a negative narrative in the news headlines, so it may sound counterintuitive as their returns have been rising amongst the debt scheme category. CRF investors are the one who seeks to generate a higher return by taking higher risk.

CRF has one of the highest risks under the debt category as it predominantly invests in illiquid lower-rated papers that have liquidity risk in case of significant and continuous redemptions.

Should investors invest in credit risk funds?

The episode of Franklin Templeton Mutual Fund in India winding up of six yield-oriented, managed credit funds, effective from April 23, 2020, is still fresh and ongoing in the minds of the investors.

That said, portfolios focused on credit risk are typically illiquid due to their strong exposure to lower-rated securities. When such funds experience big redemptions, they may run into difficulties.

In the event of a default or downgrading and winding up, the impact on the Net Asset Value (NAV) of the scheme will be significant and may potentially result in redemption pressure. Further, the significant redemptions might result in an unanticipated increase in the concentration of illiquid, lower-rated securities in a fund’s portfolio, as the liquid, higher-quality securities are sold first.

As per a report by The Economic Times, many mutual fund houses have increased their exposure towards higher-rated securities in order to improve and clean their portfolio quality. That said, while credit risk funds now appear more attractive than they did a year ago, investors should be vigilant for any change in risk profile. Avoid being swayed solely by the previous year’s return.

Further, only individuals with a sufficiently high tolerance for risk should consider these funds. The fund selection process is equally crucial in this space—ascertain the portfolio composition for credit quality and diversity.

The Securities and Exchange Board of India (SEBI) on June 7th, 2021, circular asking mutual fund houses to classify all debt schemes on the basis of the Potential Risk Class (PRC) matrix based on interest rate risk and credit rate risk.

“It was the need of the hour as it is very difficult for individual investors to perceive the risks in debt mutual funds. The biggest risk an investor faces is that he would have to monitor the portfolio constantly. Herewith this matrix, an investor is ensured that in the future too the fund house will have to stick to the mandate in terms of duration as well as credit risk,” says Juzer Gabajiwala, Director, Ventura Securities.