Credit risk funds play it safe

Portfolios of credit risk funds seem to convey a sense of safety now, changing much since the Franklin Templeton episode triggered a net outflow of ₹19,239 crore (35 per cent of the then AUM) from these funds in April 2020.

Over the course of the year ended July 2021, the sovereign debt, AAA and AA/ AA+/ AA- rated corporate debt exposure moved up for these funds, while exposure to the riskier A/ A+/ A- debt paper holdings was trimmed (see chart).

Today, there are 17 credit risk fund schemes offered by different mutual fund AMCs. Such funds are meant to invest in debt papers of relatively lower-rated issuers for higher returns — they must invest at least three-fifth of their net assets in AA and below-rated debt papers. Another 10 per cent must be in liquid assets. The rest can be invested in papers of any credit quality.

Up the quality ladder

Data from ACE MF show that seven credit risk funds have seen their exposure to AAA-rated corporate debt instruments go up during this one-year period. Among the ones that saw the biggest rise in exposures were Nippon India CRF and PGIM India Credit Risk Fund (CRF).

According to Sushil Budhia, Senior Fund Manager, Nippon India MF, the low base of last year after AAA-rated papers were sold off to meet redemption demands, and lower availability of good corporate debt issues in the AA and below segment at a good pricing have contributed to this rise.

Besides, 11 out of the 17 credit risk schemes had a larger proportion of AA/ AA+/ AA- corporate debt instruments in their portfolios by July 2021, compared to a year ago. Credit risk funds from Nippon India MF, UTI MF, IDBI MF, HDFC MF and ICICI Prudential MF experienced the sharpest hikes. Their exposure to such debt instruments went up 13-27 percentage points between July 2020 and 2021.

“The AA segment provides good credit spreads without excessive credit risk. As a result, the overall exposure of credit risk funds has moved towards the AA segment,” says Kaustubh Belapurkar, Director- Research, Morningstar India. Though corporate bond spreads have been narrowing over the past year until July 2021, three-year and five-year AA-rated bonds still offer an additional 80-86 basis points over comparable AAA-rated bonds in this period, making them reasonably attractive.

Alongside, 11 schemes (not necessarily the same ones as above) brought down their exposure to risky A/ A+/ A- debt papers between July 2020 and 2021. IDBI CRF, Nippon India CRF, PGIM India CRF and Kotak CRF saw the largest exposure cuts of 20–39 percentage points during this period. Greater caution in the post pandemic period, along with the need to be able to smoothly manage redemptions may have triggered this move.

Comfort in safe assets

SEBI’s new liquidity rule for open-ended debt funds has meant an increase in the percentage of cash and sovereign debt instruments with credit risk schemes over the past year. The rule mandates that these funds hold 10 per cent of their net assets in liquid assets, including cash and government securities. By July 2021, 12 credit risk funds had upped their cash holdings from what it was in July 2020. In this one year, the sharpest hikes (16 to 42 percentage points) were seen in credit risk funds of PGIM India MF, DSP MF, Baroda MF, BOI AXA MF and Kotak MF. For both Kotak CRF and DSP CRF, maturing debt papers towards July-end 2021 bumped up the schemes’ cash levels beyond the mandated minimum. This should change once the cash is deployed. By July, 10 credit risk funds also had a higher proportion of the ultra-safe sovereign debt instruments than a year before.

What’s in store?

A combination of factors has led to a situation of reduced risk in the portfolios of many credit risk funds. While this may be a positive from a risk point of view, this could possibly suppress future returns. In the last one year, the credit risk fund category return has averaged 8.3 per cent. In comparison, safer corporate bond funds returned a lower 5.2 per cent in this period.

Pick-up in credit growth and higher debt issuances in the AA and below-rated segment could, however, provide more investment opportunities for credit risk funds. Investors must look out for changes in the risk profile of these funds for an indication on future returns before they take the plunge.

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