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Credit risk funds and low-rated deposits not for average investors

Investors looking for a steady income and wanting to minimize their risks should stay away from credit-risk funds

July 21, 2020 / 11:00 AM IST

Falling interest rates have made life difficult for fixed-income savers. Small saving schemes and other investment options offering assured returns have seen reduction in rates. A BofA Securities report expects a 50 basis points cut in policy rates from the Reserve Bank of India by October 2020.

But does that mean you should invest in fixed deposits with low ratings or credit risk funds?

Risks persist in Indian economy

CARE Ratings recently released a report, in which it has observed a notable decline in credit quality of Indian companies. Modified credit ratio – the ratio of upgrades and reaffirmations to downgrades and reaffirmations – declined to a 26-quarter low in first three months of the current financial year. Only 5 per cent of the entities reviewed in Q1 2020-21 witnessed rating upgrades, whereas the proportion was 13 per cent a year ago. Around 16 per cent of the entities saw a rating downgrade, up from 14 per cent in Q1 2019-20. The downtrends are surely the flavor of the day.

“After moratoriums end, there is a higher possibility of downgrades in the bond markets than upgrades,” says Ashish Shah, founder of Wealth First Portfolio Managers.

Focus on risk-adjusted return

International bodies and rating agencies expect India’s GDP to contract by 5-10 per cent. That could hurt credit risk funds.

Credit risk funds invest at least 65 per cent of their corpus in bonds with AA and lower ratings. The credit risk is expected to deliver extra returns. However, over last three years, credit risk funds have given only 1.07 per cent compounded returns, compared to 8.55 per cent delivered by Banking & PSU bond schemes, according to Value Research. In the last one year, the best-performing credit risk fund has given 12.43 per cent return, whereas the worst one lost 47.05 per cent. Fund selection, therefore, becomes critical.

Should you invest in credit risk funds?

The average yield to maturity of all credit risk funds stands at 9.5 per cent, compared to 5.5 per cent for banking and PSU bond funds.

“Credit risk funds need a stable or improving credit environment to outperform other debt categories,” points out Vikas Khaitan, co-founder at Fintrust Advisors. Investors looking for a steady income and wanting to minimize their risk should stay away from credit-risk funds.

Saji Pulikan, co-founder and CEO of also prefers to steer clear of credit risk funds for the next 6-12 months. “Instead, invest in banking and PSU bond funds with some exposure to AA and lower rated bonds. If interest rates keep going down, then investors may get to pocket some capital appreciation,” Saji says.

Credit risk funds are not for average fixed income investors. You should have the stomach to digest high volatility and occasions of fall in net asset values after a default is recorded. But if you have nerves of steel, then you can consider investing a small portion of your corpus in credit risk funds to benefit from high yields prevailing now.

Nitin Rao, CEO, InCred Wealth says, “The stress in the economy has already been captured in the attractive spreads offered by credit risk funds over the repo, approximately 5 to 6 per cent, taking the yield to maturity of some funds to over 8 per cent.”

Devang Shah, deputy head-fixed income Axis Mutual Fund predicts better times, sooner than later. “Economic activity is expected to see significant recovery in the second half of the year. Investors can then consider investing in credit risk funds that are well diversified across issuers and has sizeable exposure to AAA rated bonds,” says Devang.

You can take a small exposure to credit risk funds if you have the appetite to stomach volatility. Make sure you invest for a minimum of three years. It will ensure that capital gains on units held (for more than three years) will be taxed at 20.6 per cent after indexation.

What about low-rated fixed deposits?

Given that FD investors typically prefer safety of capital, avoiding risks is all the more important. For example, senior citizens should stick to SCSS (senior citizen saving scheme) and Pradhan Mantri Vaya Vandana Yojana. Ashish also recommends tax-free bonds issued by state-owned companies.

If you still left with some surplus, you can invest in the National Saving Certificate offering 6.8 per cent or Postal Time Deposit Account with interest rates of 5.5-6.7 per cent. Housing Development Finance Corporation pays 6.41 per cent on 15 months’ fixed deposit; for similar tenure of HDFC Bank offers only 5.25 per cent rate of interest. While opting for any such investments, do not forget to assess such investments on the liquidity parameter.

Nikhil Walavalkar
first published: Jul 21, 2020 11:00 am