Will credit risk debt funds make a comeback?

Debt Funds and Debt Credit Quality

The credit quality index, a gauge of the overall quality of the debt in the country, is on the rise. Debt market experts see this as implying that corporates are better placed to service their debt obligations. If you invest in debt funds, then this is relevant for you.

Better fundamentals

The CareEdge Debt Quality Index (CDQI) has been on an upward journey since November 2021. The index was at 93.54 points in May 2023 compared with 91.41 points in November 2021. This uptrend was seen after a period of consolidation that started in March 2020.

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Milind Gadkari, Senior Director, Care Ratings says, “Rising issuance of high-quality bonds and relatively more upgrades than downgrades have led to sustained increase in the CDQI. The good part is that upgrades have been seen across sectors and rating segments.”

Post pandemic, many companies have recapitalised their business. Deleveraged balance sheets, and improved cash flows on account of better profitability has put many corporates in a sweet spot, leading to upgrades in ratings. In spite of concerns over a delayed monsoon pushing up inflation and thereby interest rates, most experts do not expect a significant hike in policy rates.

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That should ensure that the stress in the financial system will be limited, and ditto for defaults.

Fixed income

On the one hand, bond interest rates are attractive, and on the other, the credit risk is going down at an aggregate level. This means that fixed income investors can expect good bang for their buck. Since there is not much of a difference between interest rates offered on short, medium, and long-term bonds, it makes sense to invest in short and medium-term bonds that mature in three to five years. Mutual fund schemes investing in these bonds are also attractive.

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Credit risk funds are also expected to make a strong comeback. In a recent interview with moneycontrol, R Sivakumar, Head, Fixed Income, Axis Mutual Fund, said that now is the time to allocate some money to credit risk funds. Credit risk funds are debt funds that put at least 65 percent of their money in bonds rated AA and below, in exchange for which they get a higher rate of interest. In one year ended June 23, the credit risk funds on an average gave 7.1 percent returns, as per Value Research.

What should you do?

Though it is a good time to invest in fixed income, you must adopt a prudent approach while allocating capital.

Joydeep Sen, Corporate Trainer, Debt, says, “Though an improvement in debt quality means reduced risk on aggregate basis for investors, they should take a measured approach while investing in credit risk funds. Opt for such funds only if they offer extra returns for the extra risk you take compared to a corporate bond fund, which only invests in high quality bonds.”

Investors should check the portfolio quality of credit risk funds. Check the net yield (portfolio yield minus the expense ratio of the scheme) of the scheme — it should be high enough to warrant your money. If you see corporate bond funds and credit risk funds offering similar net yields, then there is no point going after credit risk funds.

Nirav Karkera, Head, Research, Fisdom, an investment firm, acknowledges that improvement in the quality of debt implies lower defaults. He advises allocating some money to low-rated bonds and credit risk funds. “Investors have to consider issuer-specific risk and the fund manager’s track record while allocating money to credit risk funds. Also consider such funds as a tactical allocation if and only if you have adequate risk appetite,” he added.

Sen also points out, “Since debt funds are now on par with bonds and fixed deposits from a taxation point of view, investors can also look at bonds with a high credit rating, or where the issuer name (goodwill) inspires confidence.”

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Though the macro-economic situation is expected to improve further with easing inflation, the risks of a delayed monsoon, spike in commodity prices, and further hikes in interest rates cannot be ignored. Stick to debt funds with a proven track record, and if you are going for specific bonds, be selective. Avoid chasing yields, especially with bonds rated below A.