Credit risk funds: A good investment bet if you pick and choose wisely

Over the past year-and-a-half, since the IL&FS episode occurred, the magnitude of credit events that have taken place in our country has been unprecedented. Many investors have burnt their fingers in a variety of debt funds due to delays and defaults in repayment of debt by corporate entities. One category that has borne the brunt of these developments is credit risk funds, whose asset under management (AUM) has got depleted by about 27 per cent over the past year.

Know your fund: Credit risk funds, by their nature, aim to earn higher returns for investors by taking credit risk. According to the Securities and Exchange Board of India’s (Sebi) definition, these funds’ mandate allows them to put at least 65 per cent of their portfolio in below-highest rated (that is, non-AAA) corporate bonds.

In India, many investors tend to enter based on past returns. The same happened in the case of When the past returns of these funds were looking good, many retail investors entered them without fully appreciating the higher risks they carried. The credit events of 2018 and 2019 dealt many of these less-informed investors a rude jolt.

Credit getting priced attractively: While this may sound counter-intuitive, we are once again close to the time when it will be okay to once again invest in The worst, in terms of defaults and downgrades, is behind us. While a recurrence of such events cannot be ruled out entirely, the pricing of credit, in terms of yields available, has once again turned attractive.

The credit culture within our country has also improved. Banks are now under pressure to not evergreen loans and do proper disclosure of non-performing assets (NPAs). Promoters who had earlier exploited the system to stay afloat are now getting exposed. The Insolvency and Bankruptcy Code (IBC) has given more teeth to financial and operational creditors to settle matters with defaulting promoters.

Moreover, mutual fund investors have undergone a lot of pain, in the form of a spate of defaults during the cleansing process. Now, even they have a better appreciation of risk. While earlier they may have only appreciated duration risk, now they realise that credit risk is an intrinsic part of investing in debt funds and needs to be guarded against.

Assess your risk appetite: Before investors decide to put their hard-earned money in credit risk funds, they should first assess their risk appetite. Only if they can take the risk of a credit event, and a possible hit to the fund’s net asset value (NAV) in their stride, should they venture into these funds. Second, the bulk of their should be in debt funds that do not take either credit or duration risk. Only a limited portion of their debt fund portfolio should be in higher-risk funds such as credit risk.


Select fund with care: Even amid the damage, some have got away without experiencing a default or downgrade in their portfolios since August 2018. The way they have negotiated the difficult credit climate of the past year-and-a-half demonstrates that some funds, and their managers, do a better job of handling credit risk than others. This then brings us to the all-important question: From the credit or default risk perspective, how can one separate the wheat from the chaff? The funds that have performed relatively better than the peer group have demonstrated a few characteristics, which we shall go into next.

Better processes: What the past year-and-a-half has brought to the fore is that some fund houses have better risk management and credit evaluation processes than others, which allows them to avoid riskier exposures. Instead of only relying on the ratings published by credit rating agencies, they have their own detailed research methodologies that allow them to weed out riskier bonds and ensure a better experience for their investors. Retail investors should make enquiries from their advisors, or other knowledgeable sources, and select funds belonging to such fund houses.

Don’t gun for higher yields: Investors also need to avoid the tendency to select funds purely on the basis of higher portfolio yield to maturity (YTM). In the marketing/sales treadmill, it is an easier sell a fund whose portfolio YTM is higher. A fund with a higher portfolio YTM, however, comes with higher risks, and hence avoiding such funds is wiser in the long run.

Opt for diversified portfolios: Make sure that the fund has low exposure to each issuer. In case of a default, limited exposure means that the loss gets contained. To limit the amount of research and due diligence they will have to do if they opt for a larger number of bonds in the portfolio, some fund managers tend to take higher exposures to a few issuers (although they do adhere to the Sebi limit of 10 per cent). But remember, in debt funds, the more spread-out the portfolio, the better. As IL&FS and DHFL, which were rated AAA at one point of time show us, credit risk is very much a part and parcel of debt

Limited investment per investor: If just a few investors account for a large portion of a fund’s portfolio, that can be risky. If they decide to exit, it can have a very destabilising effect on the fund. Some funds have limited the amount of corpus that a single investor can have in a fund. ICICI Credit Risk Fund, for instance, limits investment by each investor to Rs 50 crore. If a fund’s corpus is stable, that enables the fund manager to mitigate liquidity risk.

Skin in the game: Some fund houses have even put their own money in their credit risk funds as a mark of their conviction in them.

The negative sentiment vis-à-vis this category led to outflows from it, as investors shifted to safer credit categories like Banking and PSU Funds. Even in such an environment, however, some of the better-managed credit risk funds managed to attract flows and expand their corpus, which shows that investors do reward funds that offer good risk-adjusted returns.

The writer is founder,