Are credit risk fund returns commensurate with the risk?Debt investors can take two types of risks in order to earn higher returns – interest rate risk or credit risk. Income funds and gilt funds take interest rate risk and try to deliver returns by investing in long-dated debt. Credit risk funds focus on credit risk, which comes with investing in lower-rated debt, which has a higher possibility of default. This type of debt usually has high yields – (high effective interest rates).

However, investors do face the prospect of defaults if the debt issuers are unable to meet their obligations. This famously happened in 2015 with Amtek Auto which badly affected the debt funds of JP Morgan AMC. This AMC was subsequently acquired by Edelweiss and is now Edelweiss AMC. It also happened in 2016 with JSPL which hit the debt funds of Franklin Templeton India.

So the question is, have credit risk funds delivered high returns to compensate for the high risk they take? As the figures below show, most credit risk funds have delivered 8-9% CAGR over the past five and three years (with just three funds delivering more). Over the past year as interest rates rose, credit risk funds returns plunged to 4-6% (with a few exceptions).

How does this compare with risk-free options?

If you are willing to stay invested for six years, the 7.75% Government of India bonds, as the name suggests, pay an interest rate of 7.75%. They are issued by the government and carry virtually no default risk.

If you are above the age of 60, you can invest in Senior Citizens Savings Scheme (SCSS) for a period of five years and get an interest rate of 8.5% or in the Pradhan Mantri Vaya Vandana Yojana (PMVVY) for 10 years and get an interest rate of 8%.

Fixed deposits of banks such as SBI will pay 6.5-7% for tenures of 3 years and above.

In other words, there are a number of virtually risk-free alternatives to credit risk funds which provide similar returns.  

Here are the historical returns on credit risk funds:

Fund 1 year 3 years 5 years
Franklin Credit Risk Fund 6.51% 8.23% 8.87%
DSP Blackrock Credit Risk Fund 4.51% 8.01% 8.58%
ICICI Prudential Credit Risk Fund 5.69% 7.90% 8.39%
UTI Credit Risk Fund 5.06% 7.94% 8.49%
SBI Credit Risk Fund 4.78% 8.04% 9.12%
Kotak Credit Risk Fund 5.04% 8.10% 8.45%
L&T Credit Risk Fund 5.00% 8.01% 8.54%
Reliance Credit Risk Fund 5.23% 7.88% 8.44%
Aditya Birla Sun Life Credit Risk Fund 5.65% 8.68%
Axis Credit Risk Fund 4.65% 7.58%
Baroda Pioneer Credit Risk Fund Plan A 6.74% 10.31%
Baroda Pioneer Credit Risk Fund Plan B 7.58% 9.71%
BOI Axa Credit Risk Fund 7.58% 9.74%
DHFL Pramerica Credit Risk Fund 4.88% 8.12%
HDFC Credit Risk Debt Fund 3.97% 7.96%
IDBI Credit Risk Fund 5.22% 6.92%
Invesco Credit Risk Fund 5.31% 8.29%
IDFC Credit Risk Fund 4.09%

Source: Value Research. Data as observed on 25th June 2018, Data for Regular Plans

What can make credit risk funds more attractive to you?

There are a few additional factors, other than returns, that can make credit risk funds more attractive to you than the government schemes described above. This applies to debt mutual funds in general.

  1. Direct Plans of credit risk funds offer returns that are 0.5-1% than the regular plans mentioned above
  2. Credit Risk Funds are taxed at 20% and get the benefit of indexation if you hold them for longer than three years. Indexation reduces the tax liability on the gains in mutual funds to account for inflation.
  3. Credit Risk Funds are liquid in the sense that they have no lock-in. Instead, they have exit loads (typically 1-3%) if you exit before specified periods of time (usually 1-3 years). However, you can still exit the fund by paying the exit load specified. These exit loads fall away when you hold the fund concerned for sufficiently long periods of time.
Author
Neil Borate

Neil Borate is Deputy Editor, RupeeIQ. He can be contacted at neil@rupeeiq.com.