Credit Risk Funds - Capitalising on the Elevated Credit Spreads

Ambrish Agarwal
Director Eastern Financiers Limited

Over the past year and a half, the liquidity concerns in the financial sector, especially within the NBFCs and HFCs, have pushed the credit spreads higher across the credit ratings. While the concerns are slowly receding, the credit spreads have continued to remain elevated at higher levels across different credit ratings.

Higher Credit Risk, Higher Yields

Credit risk refers to the probability of an event where the company might not service the principal and interest obligations on time. The investors gauge the credit risk related to the debt securities through credit ratings ranging from AAA to D, wherein AAA reflects the highest level of safety concerning the fulfilment of the debt obligations by the issuing company.

As the level of credit risk reflected by credit rating increases, the investors tend to expect fair compensation for the higher credit risk, which is reflected by higher credit spreads. As such, an AA-rated bond will generally be issued at a higher coupon rate than an AAA-rated bond. As at the end of November 2019, the credit spreads for AAA-rated 10-year bond is 0.60 per cent, as against 3.06 per cent for a 10-year bond with credit rating A- (Source – CRISIL). As such, debt funds, especially the credit risk funds, have indeed emerged as an exciting investment option with a potential for a higher tax-efficient and stable returns.

Credit Risk Funds – a Targeted Debt Fund Category capitalising on Varied Credit Risks

Credit Risk Funds are a special category of debt funds, which aim to capitalise on the higher credit spreads on securities with lower credit ratings. Such funds invest at least 65 per cent in debt securities with a credit rating lower than the AAA credit rating. In other words, such funds invest predominantly in AA or below rated securities. Thus, credit risk funds allow the investors to generate better returns than the market’s fairly price, lower-rated securities with higher credit spreads.

Credit risk funds aim to generate returns primarily through accrual income and by investing with the right time horizon. Since the focus is not on specific events for generating returns, the macro event-specific impact is generally low. As such, credit risk funds aim to serve as an all-weather fund for the investment portfolios. The investors may also be further benefited by the returns getting topped up on account of potential rating upgrades and consequently, reduced credit spreads resulting in price appreciation.

Mitigation of Investment Risk

While the investment in lower-rated securities may attract a word of caution for the investors, the higher credit risk is generally mitigated by the fund managers after adequate research and portfolio monitoring. Maintaining a welldiversified portfolio with varying credit ratings and different durations can be another way adopted by the fund managers to mitigate the credit risk to some extent. Many fund houses also set an internal limit for the single issuer and group exposures to reduce the concentration risk on such funds.

Debt markets are also peculiar in terms of liquidity risk associated with the redemption of the debt securities. While a bond may be sufficiently liquid when the times are right, the liquidity for such a bond may quickly dry up. As such, it may get difficult for the investors to sell such holdings in the market at a fair price if the ratings are downgraded. To manage the liquidity risk, the credit risk funds may adopt a strategy to have adequate exposure to high-quality papers to cater to sudden redemption pressures.

Generating Tax Efficient Returns

The taxpayers are eligible for special tax rates on long-term capital gains from debt funds, including credit risk funds, and such tax efficiency makes these funds more attractive for the investors. As per the provisions of the Income tax laws (as amended upto Union Budget 2019), the investors must pay tax at 20 per cent after availing the benefit of indexation instead of regular tax rates applicable to the individual, if the investment has been held for 3 years or more.

As such, the investors with moderate risk appetite may consider investing in Credit Risk Funds to capitalise on the present high yields in the debt markets, further helped with the potential of capital appreciation, as and when higher credit spreads steadily moderate. 

The writer is a Director, Eastern Financiers Limited 
Email id : ambrish@easternfin.com 
Website link : www.easternfin.com