These debt funds are defying gravity, but is the risk worth the return?

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What’s working in favour of these funds, and can the outperformance continue?

Strong tailwinds

Credit risk funds seem to have come back into focus recently, with a few standout schemes delivering high one-year returns of over 20 percent.

These returns are driven by several factors. The credit environment has improved, reducing the risk of defaults, allowing fund managers to benefit from rating upgrades, which boost bond prices. Some gains also come from successful interest rate bets or investments in bonds that recovered after earlier downgrades.

There are three levers in fixed Income – duration, liquidity, and credit. The duration lever has been in play given the increased liquidity as well as expectation of rate cuts, resulting in interest rates settling lower.

“Over the past few months, spreads of the highest rated AAA / AA+ rated bonds have been compressed. However, the same is yet to happen in AA / AA- rated papers. We expect that spread compression in lower rated papers will play out over the next few months, and funds that primarily invest in these are likely to benefit from the same,” said Sunaina Da Cunha, Co-Head, Fixed Income, Aditya Birla Sun Life AMC Ltd.

Additionally, with falling interest rates reflecting in corporate bond markets faster than in the banking segment, many issuers have shifted their borrowing to corporate bond markets, resulting in the availability of good quality corporate paper.

Further, with increased M&A activity, quality issuances are happening at attractive risk adjusted returns.

According to Vivek Ramakrishnan, Vice President, Investments, DSP Mutual Fund, credit risk funds have benefited both from capital gains due to a rally in Indian government bonds (duration factor) as well as higher yield from lower rated accrual papers (those that pay the interest on maturity).

“While the credit environment has turned choppy with the slowing down of the economy and problems in segments like unsecured loans and microfinance, there have been no major incidents. This also helps the sentiment,” said Ramakrishnan.

Outperformance to continue?

ABSL Credit Risk Fund has delivered around 18 percent on a one-year basis till May 29, 2025, shows data available with ACE MF, a mutual fund research platform.

According to Da Cunha, with the duration gains mostly behind us, lower rated accrual papers will play an important role going forward. “Spread compression in AA / AA- rated papers as well as availability of quality corporate paper will result in credit funds being able to invest in papers yielding good risk adjusted returns,” she said.

DSP Credit Risk Fund is the best performing fund in the category with around 22 percent returns on a one-year basis.

Ramakrishnan is of the opinion that if economic growth stalls a lot, rate cuts could lead to a rally in Indian government bonds (IGBs).

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“However, weaker economic growth could have an adverse impact on the credit profiles of companies. So, we always look at the guardrails – which boils down to an assessment of the resilience of companies through economic cycles. From where we stand now, the pace of returns may slow down, but it is worth keeping a core portfolio invested in credit risk funds for the reasons outlined earlier,” he said.

A good fit for retail investors?

While recent returns from credit risk funds have been slightly higher than historical averages, this is mainly due to just one or two standout funds, not the entire category.

Arjun Guha Thakurta, Executive Director at Anand Rathi Wealth, believes that it is unlikely that such outperformance will continue over the long term.

“The average yield-to-maturity (YTM) for these funds is around 6.1 percent, lower than the 10-year government bond yield of about 6.22 percent,” Thakurta explained.

The high returns in the past year are mostly because the credit spread has shrunk from 2.5–3 percent pre-Covid to just 0.5–1 percent now, making these funds less attractive of late given their higher credit and liquidity risks. As spreads normalise, returns are expected to flatten, and investors should not expect the recent outperformance to continue, especially when there are safer options like government securities or high-quality corporate bonds.

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Credit risk funds also come with significant risks, the main being the possibility of default by issuers of lower-rated bonds. Along with credit risk, these funds are also exposed to liquidity risk, as lower-rated bonds can be difficult to sell in times of market stress.

“For most investors, the risk-reward profile of credit risk funds is not appealing, especially when the average yield is lower than that of government securities. If an investor is willing to take on this level of risk, it may be preferable to consider equity investments, which offer better risk-adjusted returns and are more suitable for long-term wealth creation,” said Thakurta.