Joydeep Sen
Credit risk funds have suddenly sprung into discussion consequent to two recent ‘credit rating downgrades’. Let us put things in perspective, in the context of investing in credit risk funds, so that the investors gets clarity on what to look for at the time of investing in these funds.
The new fund category norms of SEBI, effective June ’18, define the contours of this category: (i) the name of the fund should denote credit risk i.e. investors should know what s/he is getting into (ii) the fund should take credit risks by investing 65% or more of the portfolio in instruments rated AA or below. Given these two facts, it is expected, though not desirable, that these kind of credit-related incidents may happen.
To give an analogy, in duration-oriented funds, when interest rates in the market move up i.e. prices come down, the impact is adverse and that is a corollary of duration funds. Similarly, in credit-oriented funds, it is a corollary that credit incidents may happen. However, practically, volatility in duration funds is higher than credit-related volatility, because:
• Price discovery is much better in duration than credit. To give an illustration, if there is an expected change in inflation or expected rate action from the RBI, yield levels in the market would react immediately. Not so similarly, if the inherent credit profile of a company is changing, yield level for bonds of that company would not react till there is a manifestation like change in credit rating or reporting of significant losses or in the extreme case, delay in servicing of coupon payments.
• Liquidity is lower in credits: In securities rated AA and below, secondary market liquidity is relatively low. Hence, even if market participants have information about any event or development at the issuing company, till there is a trade, it is not expressed.
• Credit incidents being few and far between, related volatility is that much lower, when compared with duration-related volatility.
• The amount of issuance and exposure of the mutual fund industry or other investors in credit-oriented securities is relatively lower than top-rated instruments. The extent of issuances and investors being relatively lower in ‘credit’ instruments, the need for trading is lower. This leads to price discovery being infrequent.
The inference from the points above is that a potential investor in credit risk funds should go by not so much of relative stability in returns of credit risk funds over duration funds, but by the risk-return profile of the category.
The risks in this category are as follows:
• Credit risk: It may seem like stating the obvious, but to state that, at least 65% of the portfolio is in high-investment-grade but less-than-highest-rated instruments. To get a perspective on the extent of credit risk, let’s look at historical data. The historical default rate, as per a study by Crisil on 10-year data, is 0.2% for AA rated instruments and 1.9% for A rated instruments.
• Liquidity: for the mutual fund investor, liquidity is just one redemption away. However, coming to the underlying instruments, secondary market liquidity is lower in investment grade instrument. The risk is, if there are sudden large redemptions in a fund, beyond the top rated liquid instruments in the portfolio, it will have to be managed by the AMC.
• Infrequent price discovery: as discussed above.
The risk mitigants are as follows:
• Against the historical default rates mentioned above, the credit related incidents are much lesser in the mutual fund industry. This is by virtue of the due diligence process followed by AMCs, the covenants built in the transactions, the tracking post exposure and the exposure norms of SEBI i.e. limits per Issuer and Group of Issuers.
• Even in the few credit related cases that have occurred, there have been no widespread redemption pressures on the industry as a whole or in the particular AMC. This shows the maturity of investors and fleet footed action of AMCs.
• One risk mitigant which investors can follow on their own is diversification across AMCs, so that the effective exposure to one credit risk fund and in particular one credit risk instrument is only so much. Though there may be overlaps in the portfolio of various credit risk funds, most AMCs have internal exposure norms. SEBI mandates maximum 10% exposure to one Issuer, but AMCs have much lower exposure to distribute the risk.
Conclusion: what to look for
Against the risks discussed above, the investors gets (a) relatively higher portfolio carry yield than AAA rated bond oriented funds, hence relatively higher returns and (b) relative stability of returns over AAA funds, as discussed above. For taking exposure, the investor should look at:
• The pedigree of the AMC / sponsor, their track record of managing credit exposures and their due diligence process;
• The portfolio credit quality and portfolio running yield, and inter-AMC comparison to gauge whether the credit risk justifies the running yield. This may be done by comparing the credit rating composition and YTM of multiple funds in the category;
• The portfolio distribution: The more well spread out a portfolio is, irrespective of the due diligence process, it reduces the risk of a credit incident.