When it comes to mutual funds, people tend to invest in equity schemes. . However, there is a large universe of debt schemes available to investors which can be utilised to meet financial goals..
One such appropriate investment product, particularly for investors who are looking for debt investments when interest rates are volatile, is a credit risk fund. As the name suggests, these funds invest in financial instruments in the debt market, typically corporate bonds, and invest predominantly in AA and below rated corporate bonds.
If you are looking for a way to have an ideal debt portfolio, one thing you need to remember is that there are many high yield schemes available. But the credit risk fund has many advantages that work better for your fixed income portfolio.
Relatively Better Yields
In the corporate bond market, risk influences the returns potential. Corporate bonds are rated based on their credit quality and the risk they carry.
For instance, higher rated paper, say AAA rated (read triple A), would typically have a lower yield than say paper that is AA rated or lower. Correspondingly, an A-rated paper would have relatively higher yields. This is how the credit market prices the risks involved in the debt market. If this sounds difficult, remember that lower rated paper tend to have a higher yield.
Here’s where the credit risk fund steps in. These funds invest predominantly in AA-rated or lower rated corporate bonds. Usually, the yields on these are marginally better. As per SEBI’s Scheme Categorization and Rationalization, Credit Risk Funds have to invest at least 65% of the portfolio in corporate bonds rated AA (or equivalent) or lower.
Enhanced Returns through Rating Upgrade
The other advantage of investing such a high proportion in lower rated papers is that often, and particularly in an economy where the prospects are improving, there’s a chance that some of these companies could get a ratings upgrade. A rating upgrade is seen as a positive sign in the credit market.
Fund houses do thorough research and more often include corporate bonds where prospects of the sector, or the geographies the company operates, and the outlook of the company is expected to improve. Such Schemes follow a rigorous credit selection process to spot mispriced credit opportunities.
Such an assessment involves looking at cash flows, asset quality, the track record of the company, business model and so on of the corporates. Once a corporate bond is upgraded, it creates opportunities for possible capital appreciation in credit risk funds.
A credit risk fund could have quite a significant number of corporate bond securities in the portfolio thereby offering the benefit of diversification. This strategy is essential in a credit risk fund because it reduces the risk of exposure the portfolio may have to any single bond.
Over the past few months, the credit market has turned svibrant with yields hardening. Market yields, however, are not static. Considering that the yields have risen, this is an opportune time to invest in credit risk funds at relatively higher yields, making the most of the opportunities in the debt markets.
Credit risk funds generate returns mainly in the form of accrual income, although some of it may also come from potential capital appreciation, as they hold papers of moderate duration. Thus, investors in the scheme stand to gain from the relatively high yields if they stay invested for longer periods.
Also, you can take benefit of the indexation that is available to such Schemes. Given that the tax incidence on these funds is lower, credit risk funds could offer much better post-tax returns for investors, thus generating higher net returns. Given the high yield environment, credit risk funds have an edge in the current market environment. However, one must consult their financial advisor prior to making investments.
(The author is MD & CEO ICICI Prudential AMC)