4 reasons why you should reconsider investing in Credit Funds

Debt investors have been a happy lot lately. The last one year returns across most bond funds look attractive. Most have given returns of anywhere between 8 percent and 9 percent. This is in the backdrop of falling FD rates.

But is this trend expected to persist? A recent commentary in media seems to suggest that RBI may stay pat on rates for the foreseeable future.

Given geopolitical tensions, Fed’s stance on rates and domestic factors such as inflation or the macros, it appears yields have little room to wriggle.

In this scenario, investors are gradually realizing that the expectation of high returns needs to be toned down. But, conditioned as they are to a relatively higher return, many seem to be diluting quality in their quest for higher gains.

As yields on high rated instruments have trended down, unknowingly there has been a rush to buy lower quality debt paper with the lure of obtaining greater returns.

Credit funds, which invest in lower-rated debt in pursuit of higher returns have stepped in to fulfill investor aspirations of high returns from debt.

This segment has now leapfrogged to over Rs 1 lakh crores. We believe there are a few factors one should consider before committing monies to these investments.

Bank credit not available:

A good number of corporates, especially ones exposed to infrastructure and the commodities sector, have significant leverage.

With fall in interest rates, they have been trying to refinance these at lower costs, but due to the large non-performing asset (NPA) provisions in the banking system, banks are unable to lend further to these entities.

Many such entities have now found Credit MFs as a lender. Thanks to the fact that these funds are looking at higher coupons which these corporates offer, there has been a spike in demand for such papers.

Thus, a part of the risk has now been transferred to MF books from banks.

Illiquidity Risk:

The Indian bond market is characterized by low levels of liquidity available in the non-gilts space. In fact within gilts, only a handful get traded on a continuous basis.

Further, in corporate bonds, hardly a few AAA rated instruments are actively traded. Low-rated bonds are hence illiquid. This carries significant risk as and when a Fund Manager needs to realign his/ her portfolio.

For instance, if the perceived economic growth bounces back, coupled with Fed rate hikes, domestic debt yields may also reflect this change.

In such a situation, should a fund need to realign its portfolio, it would find it tough to unload its weight of low credit instruments.

Since we now know that these low credit bonds are sparsely traded, we will now talk about valuation or pricing risk. It becomes very difficult to identify a transparent price for these bonds as the secondary segment is almost dormant.

This, in turn, may create a situation that these instruments could be valued at yields/ prices that may at times artificial, without truly reflecting the underlying market.

While most valuations are done on the basis of spreads over benchmark yield, it still remains ambiguous.

Secondly, with the surge in demand for these instruments, yields on low-rated bonds have gone down significantly in the last few years.

Whilst earlier there were only a few buyers of these bonds, a segment that has now touched Rs 1 lac and is growing rapidly. It is putting pressure on yields to go down.

This is despite the fact that the underlying issuer’s fiscal situation has not strengthened significantly.

Cost of managing:

While clearly, these funds are allocating to lower rated paper to earn higher returns, it should also be realized that the end investor is not fully realizing this return in entirety.

A good number of these credit funds end up charging a pretty high expense ratio on the scheme. It is common to have expense ratios of upwards of 1.50 percent on a low credit portfolio that generates around 9.50 percent.

This is around 15 percent of the coupon earnings of the portfolio. Most entities who manage these portfolios claim that expense ratios are higher as the monitoring of these instruments is all round the year.

Nevertheless, the end result is that the investor takes a relatively higher risk with an expectation of higher return, but ends up paying a high fee for this.

In summary, we believe debt investors are better off allocating to clean debt portfolio which allows them to sleep peacefully. After all, debt is to protect the portfolio and not add undue risk.