Is It The Right Time To Invest In Credit Risk Funds?

Is It The Right Time To Invest In Credit Risk Funds?

As this report indicates, there is room for credit risk funds to provide better returns as the spreads between AAA and AA are still attractive, though not as attractive as they were in the aftermath of the Franklin Templeton fiasco

Moody’s on October 5, 2021 changed the outlook on India’s sovereign ratings to stable from negative and maintained its rating at Baa3 for India’s foreign currency, local currency long-term issuer ratings and the local currency senior unsecured rating. The change in outlook was because they believed that the downside risks from negative feedback between the real economy and financial system are declining. As previously anticipated by the rating agency, with capital cushions and greater liquidity, banks and non-bank financial institutions carry much lesser risk to the sovereign. Nevertheless, another rating agency, Fitch reaffirmed its BBB sovereign ratings on India, which is the lowest investment grade to India’s sovereign rating. Fitch Ratings maintained its negative outlook as it is of the opinion that India has a high public debt, a weak financial sector and some lagging structural issues.

Fitch Ratings warned that India might witness a rating downgrade if it fails to reduce the general government debt and GDP ratio. A structurally weaker real GDP growth outlook due to continued financial sector weakness or lacking reform implementation could further weigh on the debt trajectory. That said, India is witnessing a rapid economic recovery from the pandemic. Moreover, financial sector pressures are also easing and even the risks are narrowing. The lending institutions expect the demand for corporate loans to rebound by the end of FY22. This is because in order to meet the rising demand for goods and services amid revival in the economic activities, corporates would look at capital expenditure.

Improving Economy and Credit Risk Funds

For a mutual fund investor who is interested in investing in debt funds, improving economic growth presents a good opportunity to take exposure to credit risk funds. Last year due to erratic credit events along with some headwinds faced by the economy, credit risk funds had begun to witness the heat well before the pandemic. Credit risk funds are a type of debt-oriented mutual funds that invest in securities that have a lower credit rating, thus giving them the name ‘credit risk’ funds. Credit risk funds in India are mandated to allocate at least 65 per cent of their portfolio in debt instruments which are rated less than ‘AA’.

Investors began to exit from this category when Franklin Templeton shut down its six debt MF schemes in April 2020. As of October 2021, the fund house has distributed around 88 per cent (Rs 23,999 crore) to investors of the total of Rs 27,333 crore assets under management (AUM) of the six shut schemes.




As can be seen, the AUM of credit risk funds had fallen drastically post the Franklin Templeton fiasco. Even though the AUM has been stable thereon, the net inflows have been rising from February 2021 and in May 2021 these moved into positive territory. This shows that gradually interest is building up in credit risk funds. Institutional investors, who are considered to be smarter than retail investors and dominate debt-oriented schemes (almost 63 per cent of the AUM), have increased their investment in these funds, which is reflected in the accompanying graph. Hence, AUM and rise in net inflows towards credit risk funds gives a lot of idea on what we can expect going ahead. Besides, what also favours credit risk fund is better credit off-take. Although there is no direct relationship between rise in credit and returns by credit risk funds, better credit growth signals good economic revival and lower risk towards low-rated papers. During FY22, credit off-take improved with non-food credit growth increasing to 6.8 per cent year-onyear (YoY) basis on September 24, 2021 from 5.1 per cent a year ago. This is more evident from the chart below.

Credit growth among public sector banks remained modest, while there has been some uptick in case of private sector banks that have provided the bulk (56.7 per cent) of incremental credit extended by scheduled commercial banks (SCBs) on a YoY basis as on September 24, 2021. On the back of a favourable monsoon and measures to support the farm sector, even public sector banks recorded credit growth on YoY basis in August 2021.




It is quite evident from the above graphs that the bank credit to industry has started to improve and can see a good improvement on YoY basis. Credit to infrastructure – which accounts for around 38 per cent of industrial credit – also showed improvement, led by credit to roads and airports. The primary driver of the overall credit growth to industry was infrastructure, followed by textiles. Credit growth to the services sector slowed to 3.5 per cent in August 2021 from 10.9 per cent in the same month last year. This can largely be attributed to the slowdown in credit to NBFCs that have been raising resources mainly from money and debt markets.

The above graph clearly shows that the overall domestic credit growth has been improving after making a decadal low of 5.35 per cent in May 2021. Credit growth has not yet reached its pre-pandemic levels. However, looking at the revival in economic activity, it seems that the credit growth is going to be robust in the near future. The second factor that gives some sense of how these funds can perform is debt-weighted credit ratio. The credit ratio, calculated as number of upgrades to downgrades, has maintained its ascending stance in the first half of FY22. According to CRISIL, there were 488 upgrades and 165 downgrades for the first half of FY22. When we calculate the ratio giving weight to debt, it shows debt-weighted credit ratio.

Historically we have seen there is a positive relation between debt-weighted credit ratio and returns generated by credit risk funds. In years 2014 and 2016 we saw credit risk funds generating returns in double-digits and it is no coincidence that both these years we saw the debt-weighted credit ratio improving. During FY17 we saw that although the credit ratio remained flat, the debtweighted credit ratio was at a five-year high. Similarly in 2014, we saw a marked improvement in debt-weighted credit ratio from below 0.3 to around 0.5.

Rising credit ratio means lower risk and hence higher return as yield declines and value of bond increases. At the end of H1FY22, debt-weighted credit ratio stands at greater than 2, which is a positive sign for such funds. The year-till-date returns from this category of funds already give a sense of the returns that we can expect from such funds. The following table shows the calendar year returns of credit risk funds:

On a YTD basis credit risk funds on an average gave 8.56 per cent returns but there were funds such as UTI Credit Risk Fund, Baroda Credit Risk Fund, IDBI Credit Risk Fund, Franklin India Credit Risk Fund and Nippon India Credit Risk Fund that gave double-digit returns of 20.92 per cent, 18.71 per cent, 15.55 per cent, 12.82 per cent and 12.80 per cent, respectively.

Should you Invest in these Funds?

To conclude, we believe that still there is room for credit risk funds to provide better returns as the spreads between AAA and AA are still attractive, though not as attractive as they were in the aftermath of the Franklin Templeton fiasco. We are of the opinion that this is for an aggressive risk-taking investor who should not invest more than 10 per cent of his debt portfolio in credit risk funds. Moreover, this should be included in the satellite portfolio and not be made a part of your core portfolio. Also, credit risk funds need to be managed actively depending upon the credit situation and overall performance of the companies and the economy. So, if you understand these nuances you can always invest in such funds as part of your tactical investment strategy.

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