Credit risk funds: Are they untouchable?

When one mentions credit risk funds, the knee jerk reaction is often a negative one.

“It’s risky – papers may default!”

“We have burnt our hands in the past.”

“We are anyway investing in fixed income for safety, we might as well invest in “safe funds” or in equity where taxes are lower?”

After all, nothing hogs headlines more than a default, and at times, even a downgrade.

However, it is time that investors should look at credit risk funds as a core part of their asset allocation – the category has outperformed not just other funds, but even broader equity funds in the past year.  In a few instances, there have been repayments from past defaulting bonds which has led to improved returns in a few funds.

But the most important story that is emerging is the quality of ‘carry’.

Generally, narratives and momentum drive investment patterns. Till lately, either equity or capital gains from long bonds have given returns to investors. Investing in gold has become the recent theme-du-jour. Credit risk has been restricted to a very narrow base and specific kind of investments – for example, via Alternate Investment Funds (AIFs), targeting HNIs. However, retail investors have ignored the quiet gains from “carry” – investing in quality lower rated bonds that offer higher yields.

Does “lower rated” trigger a negative response? It should not! Mutual funds have been conscious of safety, even as returns played the biggest role in delivering quality returns. Credit ratings, important as they are, tell you only part of the story. Many quality companies, some even belonging to leading industrial groups were rated low a few years ago – Tata Steel, Bharti Airtel, Hindalco, to name a few.  The default probabilities of these companies were very low. But the ratings were reacting to a point in the cycle.

Therefore, we need to be less fussed about the ratings per se. Remember that the biggest defaults that shook the market were from AAA rated companies – and many lower rated companies who were affected thrived later.

So, then what ensures “safety”? Our fundamental belief is that good governance leads to lower default probability. And that gives you safety. Good governance is not the preserve of highly rated companies only – it is present even in lower rated companies! Evaluating this, of course, is tricky (involves extensive reference checks and cross verifications) and subjective but pays dividends in the long run.

In fact, even while investing in equity, funds place a lot of credence on governance. After all, credit is a bridge between rates and equity. Invest in the right companies, regardless of a ratings driven mindset, it gives you good returns without losing sleep.

That said, the path of a lower rated credit company can be noisy. They are lower rated for a reason, their size may be small, leverage may be higher than a AAA rated company or the relative stability of returns may be lower. Talk about noise - RBI banned a few NBFCs in 2024 from doing fresh business for a period – in this instance, good ALM profiles and financial flexibility helped the affected companies sail through this period of crisis. In the larger picture, the ability of companies to manage risks is something that needs careful assessment

Investors should understand that in most cases liquidity (ie. ability to sell a bond quickly) rather than credit risk dominates while taking higher risks portfolio. Knee-jerk reaction, looking at negative news, can be counterproductive. Credit funds are best with patient investors who fully understand how a fund positions the portfolio, can hold through noise, and has a time horizon of at least three years.

In the fixed income space, tactical allocations ie. get in and out with gains, should be restricted to more liquid funds – say those that invest in IGBs or AAA papers. For credit risk funds, patience is the key.  Allocation should be measured on the basis of genuine staying power and seeing through the noise.

(The writer is VP - Investments, DSP Mutual Fund)