Has the time come for credit risk funds again? Yes, says R Sivakumar of Axis MF

R Sivakumar-Head- Fixed Income, Axis Mutual Fund

The Reserve Bank of India (RBI) on June 8 kept the policy rates unchanged for the second straight time. Although inflation is on its way down, it is still away from the 4 percent target.

What should debt fund investors do?

R Sivakumar, Head-Fixed Income at Axis Mutual Fund, says that among other avenues to earn a regular income, it’s time to look at credit risk again. But in a measured way.

Sivakumar has been with the fund house since its inception in 2009. He has been leading the fixed-income team since 2010. The fixed-income team currently manages assets worth Rs 89,234 crore across 28 schemes as of May 31, 2023. The fund house managed to navigate the credit crisis well for the investors, and for that, Sivakumar gives credit to the risk management practices the fund house has put in place.

Credit risk is not the same as it was before

Credit risk funds were shunned by many investors after the credit crisis that followed the meltdown of Infrastructure & Leasing Finance Corporation (IL&FS) in October 2018. Credit risk funds invest a minimum of 65 percent of their funds in bonds with AA and below ratings.

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But all that is in the past, says Sivakumar. "Look forward," he says. "In the post-COVID era, credit has probably emerged as the best-performing segment of debt mutual funds, while most investors have stayed out of it." He says that the spreads (the difference between yields of lower-rated securities and higher-rated securities) may not be as wide as they were around five years ago, but they are still reasonable. To be sure, a higher spread means that yields are high and prices are consequently lower. When interest rates begin to fall, yields fall, and prices rise substantially.

"If the investment cycle in the economy picks up, we should see more issuances in AA or A-rated bonds, which will offer value for many investors who are looking for higher yields," he adds.

Sivakumar says that now is a good time for investors to allocate some money to credit risk funds. "If they are not comfortable with a pure credit risk scheme, they can still achieve some exposure to high-yield bonds by investing in medium-term bond funds, or fund of funds (FoFs) that allocate some money to AA-rated bonds or credit risk funds, respectively."

That brings us to the big question -- When will interest rates start to fall? Sivakumar says there is still time. "The El Nino impact may lead to a large surge in inflation this year, and the RBI wants some flexibility to react to that situation. Second, is the possibility of the US Federal Reserve hiking the fed funds rate higher. If, for example, the US Fed rate goes to 6 percent or so, then the repo rate at 6.5 percent is low. This may put some pressure on currency; there may be outflows," he says.

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"A cut in the repo rate is at least six to eight months away," he adds.

Where to invest in debt funds?

Sivakumar finds duration strategies attractive. Long-duration funds have returned 11.74 percent over the last year ended June 8, 2023, according to Value Research. Many distributors and advisors have started advising their investors to start investing in these schemes.

The 10-year benchmark yield is currently around 7.012 percent. Around 2021, it was at around 6- 6.25 percent.

"We should be running duration portfolios, as we are at the peak of a rate cycle. But that does not mean you need to necessarily buy 10-15 year G-Secs. Short- to medium-term bonds can be bought. If rates are cut, then the short-term yields are likely to fall more than the longer ones," he adds.

If you have a longer time horizon, say five to seven years or more, invest in long-duration funds and dynamic bond funds.

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However, a point to note is that the 10-year benchmark has already corrected to 7 percent from a high of 7.6 percent last year as inflation expectations of investors have moderated.

If you are still worried about interest rate risk and hanging on to liquid funds, it is time to move to other debt funds where your investment horizon matches with fund’s duration.

Change of debt fund taxation

But aren’t debt funds now unattractive, post the removal of long-term capital gains tax (LTCG) benefits? Sivakumar doesn’t think so. “The government has given a clear message to not use debt funds as tax arbitrage. Target maturity funds and closed-ended funds were offering fixed deposit-like returns, with tax advantage of long-term capital gains treatment.” With this arbitrage gone, Sivakumar believes that inflows will get affected. But on the brighter side, he adds, investors should look at MFs for professional management offering some extra returns over traditional investments through active management.” He further points out that the returns on debt funds get taxed only at the time of redemption and thus it is still a vehicle to defer tax liability.

Diversification matters

The fund house has a risk management framework that calls for restricting exposure to each issuer to 5, 3 and 2 percent if the issuer’s rating is AAA, AA and A respectively at scheme level. However, the regulator has set the caps higher. “We prefer to stick to our internal framework. In very few cases, like AAA-rated PSU issuers or select corporates, you would see the exposure going to 10 percent, which is well within limits specified by the regulator,” says Sivakumar.

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When you diversify your portfolio in equities to reduce risk, then you also dilute returns, as your best ideas get less money. In debt, the yield difference on bonds with same ratings do not change much. So, a diversified portfolio of AA-rated bonds will have a yield that is similar to that of a concentrated portfolio of AA-rated bonds. But in case of default or downgrade in your portfolio, then the outcomes differ a lot, when you are holding is 10 percent in that bond or 2 percent in that bond,” he added.

Bullion for hedge

When asked his view on investing in gold and silver, he said, “Bullion commodities act as a good risk hedge. We do not see much correlation between gold and equities. But when there are large dis-allocations in markets, gold tends to do well. We look at exposure to bullion to balance out the risks, not from the point of making alpha out of these allocations.”