By investing in AAA oriented portfolios, you are that much better off, but you cannot avoid credit risk completely.
In an earlier article, we had discussed the contours of credit risk funds, the risks and the mitigants. Today we discuss a related but slightly different concept: the objective of ‘avoiding’ credit risk.
To think of it, for any market related investment, the concomitant risks are part and parcel of it and seasoned investors are aware of it. However, some investors believe that investments in only AAA rated funds/instruments helps them avoid credit risk. That is the context of this discussion: as the IL&FS default case shows us, an erstwhile AAA rated issuer can default. Going through the cases of defaults or sharp rating downgrades in the mutual fund industry shows us that these occurrences are not just in credit risk oriented funds or in AMCs that are known for managing credit-oriented portfolios. It may happen with AMCs that do not run a credit risk fund or in a fund that has a conventional portfolio of high credit quality.
Where does that bring us? If as a policy you avoid credit risk funds and invest in AAA oriented portfolios, you are that much better off. The default history of credit rating agencies shows us that in AAA rated instruments, historical default rate is zero. This track record will hold good even after the IL&FS episode, though the rating agency data is yet to be published for this period, as on the date of default IL&FS was rated less than AAA. However, the point is, by investing in AAA oriented portfolios, you are that much better off, but you cannot avoid credit risk completely. Over the last couple of months, apart from IL&FS, there were negative noises about two large private sector housing finance companies. Both these companies were rated AAA, are still rated AAA and the negative noises are abating now as they have been honouring all their payment obligations. The point is, default and question marks were about companies that are not the typical stuff of credit risk funds but that are / were rated AAA.
What should you do then? To get the basics right, interest rate risk (i.e. market volatility risk) and credit risk are inherent in fixed income investments. It is possible to ‘manage’ or ‘optimize’ e.g. by reducing duration you can reduce volatility risk and by investing in highest credit-rated instruments you can reduce credit risk. However, it cannot be eliminated altogether. Rather, there are some simple, practical and easy methods of credit risk management, apart from top credit rating discussed earlier.
== Diversified fund portfolio: As per SEBI rules, a Mutual Fund Scheme can invest maximum 10% in instruments issued by one Issuer and maximum 20% in instruments issued by one Group. Within the SEBI norms, an AMC can frame internal norms that are more conservative e.g. maximum 5% in one Issuer. Since you never know what can go wrong, it is prudent to limit your exposure to so much. Just have a look at the fund portfolio and see whether the exposures are spread across many instruments / Issuers or are concentrated in a few.
== Diversify your portfolio: Spread your corpus across multiple funds. Your exposure to one particular Issuer is limited to that extent, give and take some overlap in fund portfolios to one particular Issuer. You cannot control fund portfolios, but you can control your portfolio. Nowadays, with less of physical paperwork and more of paper-less electronic processes, it does not take that much more time or labour to manage / track multiple fund exposures.
== Even within a given credit rating, there are shades. Within AAA rating, PSUs are supposedly better credit than private sector, which is why the yield is relatively lower in PSU instruments. If you choose PSU oriented AAA portfolio, you are better off and nearer to ‘avoiding’ credit risk. From this perspective, a AAA rated banking-and-PSU-debt fund is a better perceived credit risk than a generic AAA oriented fund.
== AMC pedigree: look for the track record, experience and goodwill of the sponsor group where you are putting your money. The bandwidth of the AMC / sponsor group in managing credits helps in crunch situations, though it may not be stated in so many words. This is beyond the official due diligence and tracking process in place at all AMCs, for handling exposures, particularly credit-oriented exposures.
== Exit decision: it is easy to advise that on any sign of trouble in an exposure in a fund portfolio, you should exit. To do that, you have to be aware about negative noises in the environment about bond / CP issuers, track your fund portfolios, and take quick decisions. When the trouble has broken out, the NAV has taken a hit and the AMC has written down the exposure, exit may not be required. Multiple accidents in one fund is unlikely and has not happened so far.The writer is founder, wiseinvestor.inYou can now invest in mutual funds with moneycontrol. Download moneycontrol transact app. A dedicated app to explore, research and buy mutual funds.