Should retail investors look at 'credit risk funds'?After the second successive interest rate hike by the RBI, many mutual fund experts have been suggesting that retail investors may consider credit risk funds for investment. You may have read it in newspapers, magazines or heard it on TV channels. Yes, they are asking you to consider these debt funds.

The reasons behind such a suggestion are the ‘higher carry’. For the uninitiated, carry rate is the difference between the borrowing rate and the return rate of the credit risk funds. The carry rate is currently high. When carry rate is high, it could be beneficial to lock in your investments at the current, elevated levels of yield. Which is why, in the past few weeks, many fund-houses have been sending emails and messages to investors pitching credit risk fund products.

Let us first understand what is this product, what kind of returns does it give and whether you are a suitable investor.

What are credit risk funds?

Credit risk funds are debt schemes. They aim to maximize portfolio yield by primarily investing in AA and below rated corporate bonds (excluding AA+ rated corporate bonds). If the rating of an instrument held by the credit risk fund is upgraded, it could enhance returns further. Also, corporate bonds carry a risk premium (higher interest rate) with respect to the Government of India (GoI) bonds which will change when the GoI bond rates change.

At present, there are 20 credit risk funds available for investors. The five biggest schemes in this category are HDFC Credit Risk Debt Fund, ICICI Prudential Credit Risk Fund, Reliance Credit Risk Fund, Aditya Birla Sun Life Credit Risk Fund and Franklin India Credit Risk Fund.

The ideal credit risk fund should generate income and capital appreciation. Typically, the fund managers of such schemes invest based on short to medium term interest rate view and shape of the yield curve. Do remember that these funds are intended for investors having a holding period of at least 3 years. Historically, credit risk funds have given between 6.7% to 9.6% in the last three year period. In the last five year period, the range of returns has been 8.35% to 9.45%.

A typical credit risk fund will have exposure to non-convertible debentures (NCDs), zero coupon bonds, commercial papers and some cash & cash equivalents. Most of the money will be in corporate debt securities. Typically, the best-rated bonds offer a little incentive in terms of gains because they are very safe and so yield is less. So, credit risk funds look to generate attractive returns through high-yielding corporate debt securities which are rated below the highest rating. When low rated debt instruments get upgraded, credit risk funds holding those securities can gain. Also, remember that credit risk funds are a bit riskier than liquid funds.

Taxation

You should also have a fair idea of how credit risk funds are taxed. Any long-term capital gains (LTCG) is taxed at 20% (plus surcharge, if applicable and cess) with indexation of units held for more than 36 months. Any short-term capital gains (STCG) is taxed at the income tax slab rate if units are held for less than 36 months.

The credit risk fund investor does not pay any tax on dividends but a Dividend Distribution Tax (DDT) is deducted at source at 29.12% ( 25% + 12% surcharge + 4% Health & education cess) for individuals and at 34.944% ( 30% + 12% surcharge + 4% Health & education cess) for any other person. The DDT is to be paid by the mutual fund after grossing-up income distributed to the investor.

In case of an investor being NRI, LTCG tax is chargeable at 10% (plus surcharge, if applicable and cess) without indexation relating to units redeemed from unlisted schemes.

What is the big deal now?

Given that some of these funds have been around for 15 years, many investors will ask what is so special about such funds today. There are some clear reasons why fund houses are asking you to invest in credit risk funds today.

The first reason is suitable market conditions. At present, the AAA-AA spreads are unattractive but AAA-A spreads are reasonable. So, credit risk funds are trying for higher allocation to AAA and A rated. Fund managers expect AA spreads to widen especially if the bank’s MCLR gets repriced higher. The generation of alpha is being attempted through appropriate credit selection rather than calls on interest rates movement.

The second reason is that credit risk funds are positioned to give 2-3% returns more than funds investing in risk-free debt instruments. Gilt funds, which invest in government securities, currently have negative returns in a one-year period. Corporate bonds carry more risk but have delivered gains.

How good is your credit risk fund?

Historical returns are not a guide for what will happen in future. However, investors can always take help in terms of choosing a good product.

* The first thing to look at is its debt fund management team. A dedicated credit team assessing the creditworthiness of the issuers enables the fund manager to make investments in private sector credits.

* Large funds of the credit risk category have lower costs i.e. expense ratio. So, it is important to invest your hard-earned money in such schemes who have large asset size.

* Study the track record of the debt fund managers looking after credit risk funds. Find out whether they have made any mistakes in terms of choosing debt products.

* Go for the very well-diversified portfolio. A large number of instruments helps to reduce concentration. Do not invest in a scheme where there is too much investment in one/two sectors, same group firms, or related common factor.

* Untimely exit from a credit risk funds is costly. While the first 10% investment units can be easily redeemed, but then exit loads can be 2-4% easily.

Investors should consult their financial advisors if in doubt about whether the product is suitable for them.

Author
Staff Writer

This article is written by RupeeIQ editorial staff.