Credit risk funds: Who is taking the most risk, who is playing it safe

Staff Writer   /   July 31, 2021

Over a year after the shock freezing of six schemes of Franklin Templeton Mutual Fund, credit risk has become a bad word. Many say credit risk funds are shying away from taking credit risk, despite SEBI norms that allow them to invest at least 65% of their assets in debt paper rated below AA+. Let us take a status check on who is playing it safe in credit risk funds, who is taking more risk than others.

Credit risk funds primer

Debt mutual funds usually follow two kinds of strategies to make returns. One, they buy safe long-term bonds and pocket gains when interest rates fall. Two, they buy bonds with lower credit ratings (and high yields) hoping these will get upgraded, or pay interest and principal.

Credit risk funds rely on the second strategy. Hence, they are free to invest over 65 per cent of their portfolios in corporate bonds below the highest credit grade.

As such, credit risk funds will give their best performance when general markets are over-estimating the risk of defaults or downgrades.

Risk matrix

First, let us take a look at the average rating allocation in credit risk funds category.

AA/AA+/AA- allocation is roughly 50 per cent. A/A+/A- allocation is 9.5 per cent. Higher risk allocation such as B/B+/B- & BB/BB+/BB- & BBB/BBB+/BBB- & C/C+/C- & D put together have less than 0.5 per cent allocation. We are ignoring sovereign, AAA or similar allocation here, because credit risk funds don’t carry any risk if they keep money in highest rated debt papers.

A/A+/A-: Who is playing safe, who isn’t

If in future higher downgrades and defaults happen in corporate bonds, then below AA bonds are particularly at risk. Given that the credit risk fund category allocation to A/A+/A- is 9.5 per cent, any number below or more than average will have to be watched. Also, since below A allocation (B, C & D) is about 0.5 per cent, investors needs to focus on credit risk funds that are deviating from category average.  

ICICI Pru Credit Risk Fund – Its allocation to A/A+/A- is 11.09 per cent, a little more than category average.

Nippon India Credit Risk Fund – Similarly, this scheme’s allocation to A/A+/A- is 10.34 per cent, higher than category average.

Similarly, there are certain funds that are playing safe with A/A+/A- allocation.

DSP Credit Risk Fund – This fund has no allocation to  A/A+/A- bucket. In fact, 92 per cent of the scheme’s money lies in AA/AA+/AA- allocation (60.5 per cent) and Cash & Equivalent (32 per cent).

Invesco India Credit Risk Fund – Like DSP Credit Risk, this scheme has zero allocation to A/A+/A- segment.

L&T Credit Risk Fund – This scheme also has zero exposure to A/A+/A- rated instruments.

HDFC Credit Risk Fund – Compared to category average allocation of 9.5 per cent, this scheme has only 4.8 per cent exposure to A/A+/A- segment. This has been possible because the fund has 50 per cent in AA/AA+/AA-, nearly 24 per cent in AAA, 10.5 per cent in Cash & Equivalent and about 8 per cent in Sovereign.

IDFC Credit Risk Fund – Like HDFC Credit Risk, this scheme too has limited A/A+/A- allocation to just 5.17 per cent.

Points to note

Remember as credit risk increases, the expectation on return also should go up. If a specific debt fund generate very high returns, check the credit risk of the portfolio.

Do note that credit rating can change over a period of time. As an investor, the risk that you should be worried about is not the risk of default but the possible downgrade in credit rating of the debt paper.

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