Credit risk funds, which were severely hit by a series of defaults and downgrades in 2018 to the beginning of 2020, have revived to offer average 19% returns in the last one year. This is when most of the other debt mutual fund categories are struggling to match bank fixed deposit returns. BOI AXA Credit Risk Fund has outperformed all the other schemes in the category giving triple digit returns as high as 150%. What has caused this stupendous performance? Should you invest in these funds to earn higher returns? How to select a good credit risk fund? Here's a lowdown.
What caused double- and triple-digit returns?
The overall macro for our country is looking really good. As per Devang Shah, co-head-fixed income at Axis AMC, strong capital, deleveraged balance sheet, liquidity getting raised, and all kinds of intervention from government and the Reserve Bank of India (RBI) to ensure that there is no accident have led to the improvement on the debt side. Over the last 12 months, Shah adds, the upgrades have outperformed the downgrades by a huge margin. Better macro has helped bring about a significant improvement in the credit cycle.
However, an investor should not fall for outliers. The massive outperformance in some of these schemes is a rideback of previous downgrades or restructured or default assets. Manish Banthia, senior fund manager-fixed income, ICICI Prudential AMC, explains that the extraordinary returns in some of these schemes came largely from recoveries out of assets which were marked at lower prices.
"The average category return has been reasonable given that the strategy run by the credit risk funds is largely accrual oriented, and since interest rates are edging higher, the category delivered better returns than other ones," Banthia says.
Is it safe to invest in credit risk funds?
Credit risk funds have been through a bad phase amid a series of corporate defaults and rating downgrades, which has made some investors skeptical of investing in them. However, fund managers are optimistic and they do not see new defaults or downgrades in the near future. As per Shah of Axis AMC, the credit cycle looks good and he does not anticipate any deterioration of credit or any credit defaults in the near term. But he cautions investors of the underlying risk in credit funds. "Investors must understand that these funds invest in low-rated papers with AA rating and below. Credit risk funds are subject to credit risk," he adds.
Overall the outlook on debt funds for 2022 remains positive. Banthia of ICICI Prudential AMC expects RBI to normalise interest rates. As this happens, the yield to maturity (YTM) on the credit funds should also move higher, making the credit space more attractive.
"We have been positive on credit risk as a category since 2020. In fact, in months of May and June 2020, this category was a screaming buy as valuations were very cheap," adds Banthia.
YTM is the estimated annual rate of return for a bond assuming that the investor holds the asset until its maturity date and reinvests the payments at the same rate as its current yield.
What kind of returns to expect from credit risk funds?
Credit risk funds are expected to offer better returns than other debt funds. As per Banthia, the returns will largely be in line with YTM minus expenses. Shah expects these funds to deliver good returns in the next 12 to 24 months on account of improved credit cycle and good credit spread. However, there is no point in chasing returns as past experiences show that going after returns has hurt investors.
Instead of focusing merely on returns, says Shah, sophisticated investors who have the required risk appetite, should look for credit funds which are well diversified to withstand any kind of volatility. "In case you see some defaults, the impact on a well-diversified credit risk fund would be very less. Also, you should look for a lower duration portfolio, with staggered maturities of papers in the fund."
