Should You Risk Your Money With Credit Risk Funds?   Sep 29, 2018

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Impact

Mutual fund houses showed you the promise of higher returns on debt funds.

They created a separate category labelling it as credit opportunities funds.

Later, the Securities and Exchange Board of India (SEBI) directed them to rename the category as credit risk funds.

Time is proving that SEBI’s action was necessary.

Will mutual funds be more responsible (and accountable) for their products and portfolio actions -- going by the recent debt market fiasco?

[Read: Is your debt mutual fund exposed to high credit risk? ]

What are credit risk funds?

Credit risk funds, a type of debt funds, invest in low rated, medium to long-term debt instruments with an aim of generating a higher yield. They invest a minimum of 65% of their assets in papers rated ‘AA’ or below. Credit risk funds usually follow an accrual strategy. This means they don’t intend to trade in securities based on the changing interest rate scenario, but desire to hold the credit instruments until maturity.  

In comparison to a corporate bond fund, a credit risk fund has higher risk exposure.

Why do mutual funds term them as credit opportunities funds?

Low rated bonds usually offer higher coupon rate and if by chance, independent credit rating agencies upgrade them, their prices rise substantially to factor in the improving credit quality.

What factors have influenced investors to invest in credit risk funds in the past?

Post demonetisation, ‘AAA’ rated papers and fixed deposits with Public Sector Banks (PSBs) fetched unattractive returns. Lower interest cost and improving fundamentals made mutual fund houses believe that the credit quality was improving across the board and this trend looked sustainable.

In FY 2016-17, Crisil’s upgrades to downgrades ratio surged above 1.0 after a gap of five years. Basically, for the first time in the last five years,  Crisil upgraded more firms than it downgraded.

Investors preferred the credit opportunities funds at that time assuming that the fall in interest rates and upgrades in the credit quality would be sustainable.

So far, credit risk funds, formerly known as credit opportunities funds, haven’t disappointed investors. As a category, they have generated 9.0% rolling compounded annualised returns over the last two years. Their 5-years performance has also been good, given that the category average returns stand at 9.6% on the compounded annualised basis.

But the tide is turning now.

Risks associated with credit risk funds…

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Contrary to the expectations if the credit profile of the debt instruments deteriorates, they get downgraded. These so-called credit opportunities funds end up taking high risk for nothing.

If credit risk funds face any redemption pressure, they might end up selling securities at incredibly high yields, which could dampen the sentiments of remaining investors of the scheme, thereby triggering an even bigger sell-off.

When interest rates go down and yield spreads narrow, sometimes, low-rated instruments manage to raise desired funds at low costs, masking them as secure instruments.

The real risk comes to the fore when some of them default on principal or interest payment or on both. One default affects the yields and spreads for all papers in the same category.

Recent experience…

The falling Rupee and rising crude oil prices have given rise to higher inflation expectations. This has forced the RBI to change its stance from accommodative to neutral. This implies that the RBI does not support lower interest rates anymore.

The liquidity problem has become more systemic in nature. Although there’s no panic in the market just yet, it takes just one bad development for the situation to go out of hand.

IL&FS default has taught mutual fund houses and debt markets a lot.

[Read: How IL&FS Rating Downgrade Will Impact Your Mutual Funds…]

Now it remains to be seen if mutual fund houses learn from their mistakes.

DSP Mutual Fund selling ‘AAA’ rated bond at 11.0% yield caused a furore in the market. Until recently, ‘A+’ instruments traded at a high yield. Was this just a one-off event or a precursor of what’s coming?

If bond yields harden to this extent, mutual fund portfolios with substandard quality may be vulnerable to a high risk of loss and may face redemption pressure as well.

[Read: Bond Yields Have Hardened! Here’s A Strategy To Invest In Debt Mutual Funds]

What’s the future of credit risk funds?

If the economic indicators continue to deteriorate in future and financially stressed companies find it difficult to service their debt, we might go back to an era where rating downgrades substantially exceeded the rating upgrades. This is the biggest threat credit risk funds face today.

Moreover, the recent experience of the rating downgrades hasn’t been encouraging either. Within a matter of a month, independent credit rating agencies downgraded ‘AAA’ rated instruments to ‘D’ which denotes default.

It’s high time independent credit rating agencies pulled up their socks. As on August 31, 2018, exposure of credit risk funds to papers rated below “AA” was Rs 40,817 crore. Although this includes the exposure to the short-term obligations, it’s necessary to account for that as well. IL&FS has defaulted on its commercial paper. This instance suggests that short-term papers may also expose investors to high default risk if these are rated and re-rated inappropriately and in an untimely fashion.

[Read: Why Your Money In Liquid Funds Is At Risk]

The verdict on credit risk funds…

Credit risk funds are highly risky in nature. And you shouldn’t look upon them just as credit opportunities funds. A small mistake in the assessment of the fund manager can shave off gains made over several months.

Debt funds are never risk-free.

What you should do?

You should take into account your time horizon and financial goals before investing in debt funds. If you have a goal due for fulfillment in the next few months, you should ideally invest in short-tenure funds. Credit risk funds are too risky for you. The maturity profile of a fund must coincide with your time horizon. That’s important for you to align your investments and safeguard to an extent.

The other measures include selecting a fund that has a dependable track record across interest rate and credit rating cycles. Any fund that has a tendency to invest in low-rated funds may one day make a dent in your portfolio.

You should always remember the basics of investing. Higher returns come only with higher risks.

Don’t be casual with your mutual fund portfolio.

But at the same time, don’t be afraid to invest in less popular funds thinking that they might disappoint you.

If you don’t have time and expertise to discover hidden gems, you can always take expert advice.

Editor's note:

Do you know unusual and lesser-known funds are capable of generating big gains for you, the investor?

But, any small sized fund will not do. After all, you do not want to pick lesser-known funds that have delivered a one-off performance.

And over the long-term, poor quality funds can lead to disappointing returns. So, you need to find and invest in the ‘right' ones.

Recognize hidden gems before the crowd discovers them.

If you think, you don't have the time and skills to do this on your own, don't lose heart. Want to know which these ‘Undiscovered' funds are? Click here to read more…

PersonalFN's brand new research report: 5 Undiscovered Equity Funds – With High Growth Potential is just meant for you.

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Happy Investing!

Why Your Money In Liquid Funds Is At Risk

Impact

Every time you are aboard a flight, the flight attendants brief you on the pre-flight safety instructions before take-off. Flight attendants perform a live demonstration in the aisle, while another attendant relays the instructions over the public address system.

The highlight of these instructions, safety first, is a principle we all follow in our day-to-day life. Right from wearing a seatbelt while driving a car to flying in an aircraft, or switching the regulator of the gas cylinder off before one goes to sleep.

So why is it that when it comes to money many of us become careless?

Pertinently, what if such carelessness is demonstrated by professionals who are hired to manage your money, along with an element of safety?

The recent IL&FS episode is another example of the carelessness fund managers deploy when they put the safety of investor’s money at stake.

Well I am not talking about debt mutual funds here, as they are risky in nature.

But, what about liquid funds? Aren’t they meant to be safe in the first place and offer liquidity to investors?

Liquid funds are supposed to be an ideal alternative to one’s savings bank account. That’s the reason their primary objective is to keep your money safe and offer daily liquidity.

Remember, returns come secondary. But many fund managers seem to be neglecting the rule and aim for a higher yield on liquid funds instead. Primarily, it’s a race to attract more investors with the higher returns on liquid funds.

Obviously, more AUM means more money and revenue to the asset management company, which takes care of the salaries and incentives of their CEO’s and fund managers too.

When mutual fund managers fail to do their homework and end up investing in debt securities issued by unreliable companies, thousands of investors suffer.

Recently, the Net Asset Values (NAVs) of several liquid and debt funds took a hit in the range of 0.5% to 8%. The losses these incurred were effectively within a span of few days.

To read more please click here.

Why Dumping Gold ETFs Now Is Stupid!

Impact

The Assets Under Management (AUM) of the Indian mutual fund industry have grown at 22.4% between August 2017 and August 2018. The growing participation of investors in equity-oriented mutual fund schemes has helped the industry record to steadily rise.

[Read: Does AUM Size Affect Mutual Fund Performance? Here’s What You Must Know]

However, following the on-going market correction, it will be interesting to see how equity mutual fund investors react in the foreseeable future.

Will they start withdrawing their investments in equity-oriented mutual funds here onwards?

Or, will the downturn invite more investments?

It’s usually observed that investors consider the recent performance of an asset to determine its attractiveness.

Take for example, gold.

When adjusted for inflation and tax, gold has generated negative returns over the last five years.

  To read more, please click here.

How The Plunge In Banking And HFC Stocks Impacts Your Mutual Fund Investments

Impact

You might be a high risk-taker, brave-heart investor. However, when shares of some of India's frontline financial institutions such as Diwan Housing Finance Limited (DHFL) and Yes Bank fall like a pack of cards, gloom takes over.

Yes Bank lost Rs 21,100 crore of market capitalisation on Friday last week. While the wealth of shareholders of DHFL witnessed a massive fall of Rs 8,177 crore.

Following the market mayhem, Housing Finance Companies (HFCs) and a few other Non-Banking Financial Companies (NBFCs), have been in the news.

Naturally, the bigger question investors are asking---‘What will happen to my mutual fund investments?'

While tracking the progress of your mutual fund investments every day isn't an intelligent idea, not taking stock of what's happening in the market regularly is equally unintelligent.

 To read more, please click here.


Fund of The Week

Why Are Investors In Sundaram Small Cap Fund Anxious

Small caps have been clearly on a losing streak this year. The loss of over 20% in this segment, has kept many investors in this space nervous.

Small cap universe being fairly under researched, the stocks in this segment tend to easily lose sentiment and are hit harder in difficult conditions like these. But they also have the ability to steal the show when the stock market's rebound for a longer rally.

Small caps are not every ones cup of tea and may be an unchartered territory for many. One needs to be ready to take big risk that comes along. Accordingly funds that focus on small cap stocks come with higher risk, although with a potential to generate extra-ordinary returns for investors. 

 Sundaram Small Cap Fund is one such scheme from the stable of Sundaram Mutual Fund. Earlier known as Sundaram S.M.I.L.E Fund, the scheme was categorised under small and mid cap funds. However, with further refining in its investment strategy, the scheme has been renamed as Sundaram Small Cap Fund, while its market-cap bias will now remain purely towards small-cap stocks.

Sundaram Small Cap Fund was once a superior performer in the small cap funds category, where it outperformed the benchmark and many of its category peers by a decent margin. However, the fund’s performance has changed drastically in the last 3 years.

To read the entire analysis, click here.


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Arbitrage: Arbitrage is the simultaneous purchase and sale of an asset to profit from an imbalance in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms. Arbitrage exists as a result of market inefficiencies and would therefore not exist if all markets were perfectly efficient.

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