As a young investor, it is very understandable that you look for the highest possible return on your investment, be it a mutual fund or any other investment. In search of such investment avenues, several young investors zero in on credit risk mutual funds. While these funds deliver high returns, they also expose the investor to a higher risk. Today, we explore these funds in more detail and try to find whether young investors should invest in these funds.
Meaning of credit risk funds and how they work
In October 2017, SEBI released new norms regarding the re-categorization of mutual funds. In that Circular, SEBI defined credit risk funds like debt funds that need to hold a minimum of 65% money in corporate bonds.
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:
What are the risks in credit risk funds?
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.
Now let us shift our focus from the return to risks that you face in investing in these funds, which are as follows:
Our view: Should you invest?
- 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.
It is said very well – “Dance till the music stops”. As investors, we need to understand one essential thing – risk, and returns go hand in hand. Higher return brings with it higher risk. The higher the risk, the higher the effort you need to manage the risk and keep it down to a manageable level. Investment in credit risk funds requires careful analysis and ongoing tracking of the investment portfolio of the scheme. You also need to keep an eye on the monetary policy and economic cycle. This is easy for someone at the investment desk of a corporate house as they have sophisticated research tools. However, for an average retail investor, it can be a next-to-impossible task.
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.
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.
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