Prime Views: Five things they don’t tell you about credit risk funds

After the Franklin Templeton debacle, CEOs of asset management companies have been out in big numbers across media to reassure investors that this was an isolated case and that there’s no crisis for the debt fund industry itself.

While this may be true, a few AMCs have also highlighted that this is a good time to buy credit risk funds. We at PrimeInvestor strongly disagree. Credit risk funds, in our opinion, are not well-suited to a majority of retail investors even in good times. This seems to be a particularly bad time to buy them.  

Here are five things they’re not telling you about credit risk funds, which you should know.

Downgrades/ defaults are likely to rise

Debt mutual funds can follow two kinds of strategies to make extra returns. They can buy safe long-term bonds and pocket gains when interest rates fall. Or they can buy bonds with lower credit ratings (and high yields) in the hope they’ll get upgraded, or at least not default on their dues in both interest payout and at maturity. Credit risk funds rely on the second strategy, investing over 65% of their portfolios in corporate bonds below the highest credit grade.

Credit risk funds deliver their best performance when markets are over-estimating the risk of defaults or downgrades on corporate bonds. If you manage to invest in such situations, you get twin benefits – high interest receipts and capital gains on the lower rated bonds when they get upgraded or markets mark them up.  

Today though, we seem to be at the beginning of an extended period for the Indian bond market where defaults and downgrades are likely to escalate. With COVID cases still rising and the likelihood of on and off lockdowns before cases peak out, the extent of damage to company finances from this whole episode is extremely difficult to estimate. Higher downgrades and defaults in corporate bonds are therefore likely in the coming months; with below AA bonds being particularly at risk.   

Rating agencies have been warning of this. A recent note by rating agency CRISIL predicted that 800 leading listed companies were likely to take a 10% revenue hit, with EBIDTA falling 15-18% in the base-case scenario for FY21. Companies accounting for 32% of the debt, it said, could see their interest cover slip to less than 1 time in FY21 (that is, their profits will not be enough to pay interest). It also expects banks to see bad loan ratios rise by 1.5-2 percentage points. CRISIL’s downgrades already outnumbered upgrades (469 to 360) in the second half of FY20 with ICRA seeing twice as many downgrades as upgrades.

To cut a long story short, defaults and downgrades of corporate bonds are expected to spike in the coming months. Credit risk funds may therefore face a larger-than-usual number of sudden NAV accidents which reduce their effective returns.

Spreads are high, but not yields

To buttress their case for buying credit risk funds, some AMCs are offering the ‘spread’ argument. With this crisis, corporate bond spreads have widened recently, they point out, which will help you earn higher yields from credit risk funds for taking on higher default risks. This is true, but there are two issues. One, corporate bond spreads on their own may look attractive today – with one to three year AAA bonds offering 174-186 basis points over comparable government securities, AA bonds offering 276-365 basis points and A bonds 212-222 basis points. But then, for investors, the absolute yield (or interest earned) matters more than the spread over government securities. But yields on government securities have fallen precipitously and are sub-5 per cent levels now. Therefore, high spreads don’t result in very high returns on corporate bonds.

If you see the above tables, AAA corporate bonds are offering yields of 5.6-6.6% for 1 to 3-year terms, AA bonds 7.4-7.6 % and single A bonds 6.2-6.8% (this is distorted by thin trading volumes). You’d agree that those yields are not very handsome compensation for taking credit risks on your capital.

Two, we can’t be sure that those spreads won’t widen further, depressing corporate bond prices in the coming months. Market prices for bonds quickly factor in risks when they are measurable and quantifiable. The risk to credit markets from COVID 19 is neither measurable nor quantifiable as yet. Therefore, the markets may not have fully factored it in.

We aren’t in charge of liquidity

One of the primary reasons why investors like to buy open end debt funds is their promise of anytime liquidity. But when you invest in credit risk funds with mainly AA or below investments, that liquidity can’t be taken for granted.

Trading in the Indian corporate bond market is always erratic for lower-rated bonds. Many institutions such as insurers and pension funds are barred from investing in below AA bonds. 

The problems that Franklin Templeton ran into with its credit-oriented funds originated neither from defaults by the issuers nor from downgrades, but from the illiquid nature of most of its bond holdings. After a credit accident involving Vodafone-Idea bonds, the AMC had to deal with higher-than-usual redemptions. This led to a downward spiral where it had to first sell its highly rated and liquid bonds and then borrow to repay, before finally throwing in the towel to announce the winding up of its schemes for an orderly payout.

Vanishing liquidity in lower rated bonds at times of crisis is a structural problem that the Indian debt market has faced time and again. In the year to March 31 2020, credit risk funds saw net outflows of over Rs 28,000 crore, leaving them with residual assets of Rs 55,380 crore. 

Credit risk funds across the board are vulnerable to illiquidity risks. No matter what safeguards they put in place, AMCs simply can’t control what might happen if their funds face sustained redemptions. The FT episode has shown us that high YTM (yield to maturity) on credit risk portfolios can remain on paper, if you can’t cash out at the time of your choice at the reported NAV.  

You’ll pay high fees

To navigate the corporate bond minefield in India, you need market whiz-kids as fund managers. They don’t come cheap. To incentivise distributors to sell these complex funds, AMCs offer high commissions. Both these add up to one thing – you end up paying through your nose. Credit risk funds charge the highest Total Expense Ratios (TERs) among all categories of debt funds.

If you run your eyes through Prime Ratings, you’ll find that the annual TERs on Regular Plans of Credit Risk Funds ranged between 1.1 % and 1.82% as per their latest disclosures. Those are eye-watering costs for a fixed income product. Corporate bond funds investing in high quality bonds, in contrast, charge 0.45% to 1.4% and Banking and PSU funds charge 0.31% to 1.13%.

The high fees on credit risk funds, apart from taking a generous bite out of your returns, actively encourage fund managers to pack their portfolios with extra high yield bonds, so that you can still take home a decent return after charging those fees. In the world of credit, high yield automatically means high credit risk.

The track record is patchy

Finally, thanks to the multiple accidents involving IL&FS, DHFL and other episodes in the last couple of years, today Credit Risk Funds as a category don’t boast of a great track record. The worst performing ones have suffered a negative CAGR of 18% over 5 years, the best ones have delivered 7.5-7.9% CAGR over 5 years. The record would have looked much better a couple of years ago. But that’s the problem with this category. When accidents happen, they wipe out returns accumulated painstakingly over many years.