Credit Risk Funds Analysis | Comparison with Conservative Hybrid Funds

Is Risk Linked with Credit Risk Funds Justified?

Introduction

Post IL&FS Collapse in September 2018, the corpus of credit risk funds shrunk almost by a quarter. Credit risk funds has been hit by a series of defaults and downgrades over the last one year. Lets do a short analysis of Credit Risk Funds performance. The sharp fall in their Net Asset Value (NAVs) have led to large outflows from this category. In such case, is the risk linked with credit risk funds justified?

Credit Risk Funds Analysis – Is Risk Linked with Them Justified?

• The primary aim of credit risk funds is to offer higher returns to the investors than any other categories of debt fund. Their basic goal is to invest predominantly in low-rated bonds in pursuit of higher returns.
• However, if we compare the returns of riskier credit risk funds with that of safer short duration funds, the result will disappoint their investors.
• In such case, many credit risk fund investor ask one question – Are these credit risk funds worth the risk associated with it?
• Many people will argue that comparing credit risk funds with short duration funds is not appropriate in the current scenario. It is because the credit risk funds are recently witnessing their worst phase due to the ongoing stress in debt markets and the resulting credit downgrades.
• In order to verify the above argument, we have compared both the categories over the last five years to evaluate their performance.

What Are Credit Risk Funds?

• Credit risk funds are debt fund which are mandated to invest a large chunk of their assets (at least 65% of corpus) in instruments rated AA or lower. They do this while maintaining the optimum balance of yield, safety and liquidity.
• Investment in lower rated bonds involves higher risk as it signifies lower capability of borrower to repay obligations and the increased possibility of defaults.
• Thus, while maintaining reasonable liquidity, credit risk funds target high accrual by taking on a marginally higher credit risk.

Investment Strategy

• Credit risk funds look out for opportunities to maximize portfolio yield. They primarily invest in AA and below rated corporate bonds.
• The funds invest predominantly in corporate bonds, which offer good opportunity to leverage credit risk. By choosing a diversified portfolio positioned for growth and stability, credit risks funds seek to provide :
  1. Regular income
  2. Capital appreciation
• To efficiently manage the risks, these funds avoid concentrated portfolios and also cap corporate group level exposure.
• Apart from their core strategy, these funds offer higher yield, with potential for capital gains in the event of a future upgrade in credit rating of the bonds. Thus adding extra alpha.
• This is because relatively low rated bonds usually offer higher coupon rate and if their ratings are upgraded, the prices of such bonds jump.

Credit Risk Funds Analysis – Comparing with Other Debt Categories

1. Credit Risk Funds vs Short Duration Funds – Comparing Returns

• Short Duration funds
  • These are debt funds that lend to companies for a period of 1 to 3 years. These funds mostly take exposure only in quality companies with rating AAA and above.
  • Those highly rated companies have proven record of repaying their loans on time as well as have sufficient cash flows from their business operations to justify the borrowing. Thus, Short Duration funds are safer than credit risk funds.
• In spite of taking higher risk, the returns of credit risk funds can not beat that of short duration funds. Over last 1-year, credit risk funds have offered merely 1.30% returns vs 6.04% that of short duration funds.
• This is mainly because of back to back downgrades of debt instruments from IL&FS and Dewan Housing Finance (DHFL) by rating agencies.

2. Credit Risk Funds vs Conservative Hybrid Funds – Comparing Credit Quality

• A good credit risk fund should have the ability to deliver 3-4% more returns than a fixed deposit or a conservative hybrid fund.
• In case of conservative hybrid funds, asset allocation is :
  1. 25% in equity : To add growth to the portfolio and
  2. 75% in debt : To generate a consistent income
• These funds look to provide more returns than bank fixed deposits without taking too much risk.
• The debt part of conservative hybrid funds is mostly in high rated securities. But that is not the case with credit risk funds.
• We can see from the above graph, the asset quality in case of credit risk funds is mainly credit rating from AA and below it. While for conservative hybrid funds, it is AAA and above.
• The returns offered by conservative hybrid funds were 8.06%, 5.84%, 7.36% and 8.37% for 1 year, 3 years, 5 years and 10 years respectively.
• These numbers are far better than that of credit risk funds for the respective time horizon.

Conclusion

• Thus, credit risk funds have not justified in terms of returns with the risk associated with them, when compared with short duration funds and conservative hybrid funds returns.
• The subdued returns of credit risk funds post IL&FS crisis, may be because of ongoing stress in debt markets due to credit defaults and the resulting credit downgrades.