The vital thing to note is that the bonds need to be below the highest-rated instruments. So, regardless of market conditions, a significant part of the portfolio of these schemes has low-rated bonds. This increases the risk of default and inferior liquidity in these schemes.
As regards return, these funds basically try to earn in the following ways:
- Investing in high-quality AAA securities (like Government securities) at the high end of the interest rate curve.
- Investing in low-rated papers which promise a higher yield.
- Credit Risk: Credit risk funds have to precisely time their investments; otherwise, there is a possibility of a loss. The interest rates may rise contrary to the fund’s expectation of a reduction in rates. Or there may be a COVID type situation where many corporates face financial stress and start defaulting on their debt obligations. These funds stand at the most risk in such situations. Any default can result in an actual loss for you as an investor in terms of a reduction in the NAV of the respective scheme.
- Liquidity issues: The Franklin Templeton issue is an obvious example of this risk. The secondary market for the trading of lower-rated securities in India is unfortunately not very well developed. As a result, the trading volumes of such securities are shallow. One big reason for this is that big institution like pension funds, and insurance companies cannot invest in these securities. As a result, in case of redemption pressure (particularly in financial crisis situations), this liquidity problem can make the fund sell the holdings at the best available price. In this scenario, the Yield to Maturity (YTM) of the securities can simply remain a number.
- No clear track record of performance: Unfortunately, credit risk funds have not yet made their impact in terms of performance. These schemes’ 3 and 5-year returns are a measly 1.68% and 3.57% (Source: Value research website). The Franklin episode has further jolted investor confidence in these schemes. The fund houses have also been more credit averse, impacting the returns of this category in times to come.
- Higher expense ratio: Investors often overlook the expense ratio in a mutual fund scheme as it gets auto-adjusted in the NAV of the scheme. The total expense ratio of 1-2% in these funds is way more than the expense ratio of plain vanilla liquid funds in the range of 0.1 – 0.5%. These expenses make a straight dent in the overall returns from these funds. To cover up for the higher expense, the fund managers buy even lower-rated securities that put further strain on the portfolio’s overall credit quality.
As a young investor learning the various aspects of personal finance, your first priority should be the safety of your savings and the liquidity of your investment. You can adopt the approach of taking a risk with only the equity component of your money at this juncture. Regarding the debt component, you can invest it in safer and lesser-risk avenues like liquid and short-term schemes. Later on, as you mature as an investor and have a greater appetite for risk, you can consider allocating a small proportion of your total investible surplus to these schemes. Even when you decide to invest, you need to be mindful of the reputation of the fund manager and the pedigree of the fund house managing the scheme.