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Credit Risk Funds are Making a Comeback: Should you Invest?

Credit risk funds have gone through a rollercoaster ride in the last few years. They gave double-digit returns for a couple of years, then negative returns for a couple of years. This article discusses how credit risk funds are making a comeback and whether you should invest.
Should you invest in Credit risk funds?

Credit Risk Funds: The rollercoaster ride of the last few years 

Credit risk funds have gone through a rollercoaster ride in the last few years. From 2014 to 2016, many of them gave a double-digit return annually. From 2018 to 2020, they were hit by a wave of corporate defaults, resulting in many credit risk funds giving negative returns. In 2021-22, credit risk funds are making a comeback, with some of them giving the best returns in the debt mutual funds category. This article discusses how credit risk funds are making a comeback and whether you should invest in them.

What are Credit Ratings?

Before we understand what credit risk funds are, let us first understand what credit ratings are. Whenever a company has to raise funds from investors through a debt instrument, it has to get it rated by a credit rating agency. The top credit rating companies in India include CRISIL, ICRA, CARE, etc. These rating agencies assign a credit rating based on factors such as debt repayment capacity, repayment track record, revenues or cash flows, existing debt, etc. The credit rating is based on a credit rating scale. 

For example, CRISIL has the following credit rating scale:

  1. AAA (highest safety),
  2. AA (high safety), 
  3. A (Adequate safety), 
  4. BBB (moderate safety), 
  5. BB (moderate risk), 
  6. B (high risk), 
  7. C (very high risk), and
  8. D (default)

What are Credit Risk Funds?

A credit risk fund is an open-ended debt fund that predominantly invests in below highest-rated corporate bonds. The minimum investment in corporate bonds (below highest-rated bonds) should be 65% of total assets. 

For example, let us assume that the credit rating scale is as follows: AAA, AA, A, BBB, etc., and so on. In this case, the highest credit rating is AAA. Credit risk funds majorly invest in below highest rating bonds. So, in this case, they have to invest a minimum of 65% of their total assets in bonds with a credit rating of AA, A, BBB, etc., and so on.

Credit default risk in credit risk funds is higher than in many other debt funds. Hence, credit risk funds are suitable for investors with a moderate to high-risk profile.

Why did Credit Risk Funds go through Turbulent Times?

In 2018, IL&FS defaulted on its debt repayment. Over the next couple of years, some other corporations like Dewan Housing Finance Limited (DHFL), Anil Dhirubhai Ambani Group (ADAG) Group, Yes Bank, etc., also defaulted on their debt repayment. These defaults hit their creditors hard. One of the worst sufferers was the credit risk debt funds that had invested in the bonds of these companies. As these funds had to take huge write-downs, the investors in these funds suffered heavy losses. Franklin Templeton had to wind up six debt funds, including the Franklin India Credit Risk Fund.

Credit Risk Funds Recovery

There has been a gradual economic recovery in the last couple of years. Corporate profitability has improved. Many of the corporates that defaulted have either repaid most of the debt or have been taken over by other corporates through the Insolvency and Bankruptcy Code (IBC). It has led to many credit risk funds recovering some or most of the lost money and returning it to their unitholders.

SEBI regulations to safeguard investors

After the credit risk funds crisis, SEBI introduced new regulations to safeguard investors. Some of these include:

  1. Side-pocketing
    • SEBI asked fund houses to side-pocket the bad assets in a separate portfolio. It has led to the removal of toxic assets and portfolio clean-up. The bad assets will not affect the new investors. When money is recovered from bad assets, it is returned to investors.
  2. 10% liquid assets
    • SEBI has asked debt funds to maintain 10% of their money in liquid assets such as Government securities (G-secs) or cash. It will help credit risk funds meet redemption pressures. With this buffer, they will not need to do a fire sale of illiquid assets at a distress valuation.
    • Apart from the above SEBI regulations, credit risk funds have reduced issuer concentration. Earlier, the top 3 or top 5 issuers would form a major chunk of the overall scheme portfolio. But, over time, credit risk funds have diversified their portfolio to reduce issuer concentration. With diversification, in the event of a default, the hit on NAV will not be much.

How are Credit Funds Faring now?

Let us look at the returns given by credit risk funds in the last two years.

Scheme nameAUM (Rs. crores)1-year2-years
BOI AXA Credit Risk77150.09%19.18%
IDBI Credit Risk Fund3417.41%14.15%
Baroda BNP Paribas Credit Risk Fund20414.82%13.06%
Nippon India Credit Risk1,18013.49%11.20%
Franklin India Credit Risk Fund3208.33%10.51%

(Source: https://www.moneycontrol.com/mutual-funds/performance-tracker/returns/credit-risk-fund.html)

Note: The returns are as of 08 April 2022. The returns are for direct plans with growth option. The one-year returns are absolute, and the two-year returns are CAGR. The funds have been ranked based on two-year returns. The 1-year return of 150.09% for BOI AXA Credit Risk Fund and the high returns for some other funds is due to the recovery of earlier written down assets.

Taxation of credit risk funds

The taxation of credit risk mutual funds depends on the holding period.

  1. Short-term capital gains (STCG) tax
    • If you redeem your credit risk mutual fund units within thirty-six months of purchase, the capital gain will be classified as short-term capital gain (STCG). The short-term capital gain (STCG) will be added to your overall income and taxed as per the income tax slab that you fall in. 
  2. Long-term capital gains (LTCG) tax
    • If you redeem your credit risk mutual fund units after thirty-six months of purchase, the capital gain will be classified as long-term capital gain (LTCG). The long-term capital gain (LTCG) tax will be levied at 20% with indexation benefit and 10% without indexation.

Should you invest in credit risk funds now?

As an investor, you should follow appropriate asset allocation based on your risk profile. Your investment portfolio should consist of equity mutual funds, fixed income, gold, and real estate. Within each asset class, you should diversify further. You can allocate some money to credit risk funds from the fixed income portion of your portfolio. You should choose your credit risk funds carefully with the help of a financial advisor and always invest for the long term till your financial goals are met.

Investing in credit risk mutual funds with the Glide Invest App

In the above section, we understood credit risk funds, their returns, and taxation. You can partner with the Glide Invest App for your financial planning journey to get recommendations for the appropriate credit risk mutual fund schemes based on your risk profile. You will get advice on planning and systematically investing towards your financial goals

With Glide Invest, you will get guidance for:

  1. A personalised risk profile assessment
  2. Identifying your financial goals
  3. Appropriate asset allocation
  4. Making a financial plan for each goal
  5. Automating the financial plan
  6. Review and analysis of your financial plan 
  7. Hand holding you till your financial goals are achieved

To start investing towards your financial goals, download the Glide Invest App!

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