One category of mutual funds that has been in the limelight in the first half of this financial year was Credit Risk Funds. The vulnerability of this category was mainly exposed due to the pandemic and sudden slowdown of activities globally.
Credit Risk Funds are debt fund that invest at least 65% of their total corpus in debt instruments that are rated AA or lower. Investments that hold lower rated debt instruments usually deliver higher risk as well as higher returns. The table below depicts the average holdings of schemes in the entire Credit Risk Fund category, in different debt papers.
From the above table it is clear that during the month of April, investments in AA & above papers was ~59% and in below A was ~31%. And in the month of August, the allocation changed with ~67% in AA & above, while in A & below investment fell to ~26%. This shows that even the Credit Risk Funds are reducing their risk by moving more towards quality paper investments. Risk is also a relative perception, as we have seen 2 major AAA rated entities also defaulting.
Generally, debt papers with rating below AAA have less liquidity and also the interest rates on the instruments are higher. In general, the lower the rating, the higher the interest rates and vice versa, to incentivise the investor accordingly.
In times of economic prosperity, generally, investors do not pay too much attention to ratings; they tend to focus only on the returns. Since the economy is doing well, even industries tend to pay less attention to risk. It is only when there is a crisis that the entire perception takes a U-turn and even the safest of companies are looked at with suspicion. This is exactly the scenario which we are witnessing with the onset of lockdowns due to COVID-19.
In last few months, there was a complete flight to safety, i.e. all the low rated debt fund investors moved to high rated debt funds and as a consequence, most mutual funds had to liquidate their holdings to meet their redemption requirements. In such situations, high-quality papers tend to get liquidated first and funds are left with low quality and illiquid instruments.
As the condition continues in the current pandemic situation, investors have become more risk averse towards risky assets. The table below shows the Assets Under Management (AUM) trend of Credit Risk Funds from the beginning of this calendar year.
Since the month of February, 2020, there has been a fall of ~54%, which clearly shows that the investors are currently distancing themselves from this category, due to the adverse risk situation. The drop has been significant in the month of April, wherein the AUM dropped by nearly 35%. Gradually, this category also saw a tapering of AUM.
The effect of redemption pressure in this category can also be seen in the performance of the fund. The table below presents the annualized returns of the category average, which shows a huge volatility in performance.
Below are some points that investors need to be aware with respect to Credit Risk Funds
1. The table below shows the average Yield to Maturity (YTM) of different debt fund categories. While calculating the average YTM of Credit Risk Funds, we have excluded Franklin Templeton, as the fund has been closed.
The gap between the YTM of Credit Risk Funds and the other two categories is around 3%. Investors can consider Credit Risk Funds, only if they are confident that-
2. Investors will have to bear the losses in the event of default of any paper, due to the mark to market and segregation of the debt funds.
3. As the current situation has stalled the entire economy, highly leveraged companies may not be able to meet their debt obligations and their chances of defaulting on loans increases.
4. In the current situation, not many investors are geared up to understand the credit worthiness of each entity. And even distributors and advisors may not have complete knowledge of the credit situation of the entities.
The current scenario is very different from what it was a year ago. Today, even a good company can face a crunch. When a business is not doing well during stable economic conditions, we can easily understand that there is some problem in that company. But currently, no one is performing well, which makes it more difficult to pick companies that are viable for investment. Only well-informed investors, who can continuously keep track of the fund’s portfolio activity and are satisfied with the compensation provided by the difference between the YTM of Credit Risk Funds and other categories, should invest. However, less hands-on investors would be better off currently staying away from investing in this category in the present situation.
Such risks can only be taken when the general economy is running smoothly because Credit Risk Funds require a stable or improving credit environment to outperform other debt fund categories. And, in the current turmoil, it is very tough to predict when the credit environment will become stable. Therefore, a lay investor should not invest in this category for at least the next 6 months. They should look at this category only when the economic condition becomes more favourable.
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We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:
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We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflicts of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.