FundsIndia reviews: The credit opportunity in debt funds

The stock market’s phenomenal performance since late 2013 may have shifted all your attention to equity funds. In the process, you may have missed out on some less flashy opportunities that debt funds have been offering. Dozens of schemes, if you take the debt short-term and income fund categories, have delivered double-digit returns in the last one year.

True, majority of these delivered returns by taking on the interest rate risk. However, there are a few funds in the income accrual category that deliver high returns for taking on a different kind of risk – credit risk – in corporate bonds. In the last six months, corporate bond and credit opportunities funds have delivered better returns than income and gilt funds, so much so that thus far in 2015, a number of fund houses launched corporate bond opportunity and credit opportunity funds.

Why corporate bond opportunity now

Corporate bond funds seek to invest in well-managed companies that show promise of growth and improving fundamentals, but the same is not reflected in their credit rating and bargaining capacity in the debt market.

Fund houses that are willing to bet on improving fundamentals take exposure to the debt instruments of such companies as they offer attractive coupon rates. Such funds aim to generate a higher income on a regular basis, without having to worry too much about interest rate movements. They do this by investing in instruments with higher coupon or accrual income (to compensate for lower credit ratings). If these instruments are not listed, then you enjoy higher accrual (interest payouts). If they are listed and their ratings improve, or the spread (difference between government bond yield and similar tenure corporate bond yield) shrinks, they see capital appreciation. That is the price of the underlying instruments rally.

In general, we believe that credit calls are tough to take and can hit a retail investor’s portfolio, especially when companies are yet to see clear signs of revival.

However, with key economic metrics showing signs of revival, and corporate balance sheets slowly de-leveraging, credit risks at this point seem lower than what it was a year or two ago. How do we gauge this?

Less downgrades: One way is to look at corporate credit ratings. Rating firms see an improvement in the credit quality of Indian companies as the number of rating upgrades have exceeded the number of downgrades by key rating agencies.

The Upgrade to Downgrade Ratio of CRISIL in 2014-15, for instance, improved to 1.75 times in the second half of the year, up marginally from 1.64 in the first half.

For ICRA, both the number and severity of rating downgrades moderated during 2014-15. Accordingly, its Credit Ratio, or the Ratio of Upgrades to Downgrades for ICRA’s credit ratings improved to 1.9 times in 2014-15 from 0.9 times in 2013-14, suggesting that fewer companies are being downgraded. That means corporate credit risk hasn’t worsened or may have gotten better. Any increase in the number of upgrades would also cause yields to ease, triggering a price rally in bonds.

Default rates: Does the AA-rated category always spell high risk? To understand this, we looked at the default rates of differently rated instruments. According to CRISIL’s historical data between 2004 to 2014, while AAA-rated instruments had zero default risk, the risk of default for long-term AA-ratings was a mere 0.03 per cent for 2 years, and 0.17 per cent for 3 years. That means not even 1 in 100 companies in this rating category defaulted.

Of course, nil default does not mean no risk. The risk of low liquidity means that a fund can be stuck with an instrument until maturity. This is why a longer tenure is called for in such funds.

With well-researched picks in the AA-rated debt category, fund houses can still avoid high credit risk and yet, enjoy higher accruals (interest). Some fund houses take sufficient collaterals (in the form of covenants, shares, real estate securities, and so on) to offset the losses if there is a default from the issuer. Others also have inbuilt agreements for priority in repayments to ensure that they exit when they see any small sign of distress.

Reasonable yields: The ‘carry’, or the accruals for a three-year AA rated instrument is, on an average, about 30 basis points (bps) higher than their AAA rated counterparts. This spread further increases sharply for instruments with an A rating. Yields on AA rated paper was more than 9 per cent in October 2014. After the three 25 bps rate cuts from the Reserve Bank of India (RBI), it currently stands at about 8.5 per cent.

Simply holding these instruments would fetch a high accrual income for the category. Of course, in the event of economic prospects improving, or when rates are cut, the yields will ease leading to capital appreciation. If you believe that the threat of an economic downturn is lower now and that a recovery is in sight, then all of the above factors put together can work in favour of this category delivering higher returns.

Suitability

Corporate bond funds are suitable only if you wish to hold it for not less than three years (please note that most of the funds have a steep exit load for redemptions before this period), and if you can take higher risks than you would for other debt funds. You should also be prepared for short periods of negative returns.

Make sure that you match your time horizon with the fund’s modified duration to ensure that your time frame matches that of the fund. Also, watch out for high exit loads. Ultimately, invest in them only if you appreciate fully the risks that they hold. The three-year holding period, besides lowering risk, will also ensure you enjoy the capital gain indexation benefit.

Category performance and portfolio ratings

The 75 bps interest rate cuts from RBI thus far in 2015 helped corporate bond and credit opportunities funds deliver double-digit returns over the last one year. Even the 3-year point to point returns (Compound Annual Growth Rate) is more than 9 per cent. Higher returns are commensurate with high risks in this category. In the past, most corporate bond funds have taken high exposure to A-rated papers to generate superior returns.

The industry’s Assets Under Management (AUM) of corporate bond and credit opportunities funds has crossed Rs. 25,000 crore. This means that they are gaining popularity, prompting other fund houses to launch similar funds. Since there is no separate category for these funds, they are classified as income funds, short-term funds, and ultra short-term funds in various websites. You should not go by the names of the fund; you should look at the holding of corporate bonds, their credit rating, and the average maturity profile of the fund before taking an investment call.

As a retail investor, this call may be a tough one for you to take. In general, the corporate bond exposure you get in regular income/dynamic bond funds should provide you adequate credit plays well. Unless you are savvy and can stomach risks, and if you can seek the right advice on these funds, they may not fit your portfolio.

Given below are a list of funds in this category that explicitly follow the above-stated strategy.

As of June 18, 2015.

Source: ICRA MFI Explorer; Ratings as of 31 May, 2015.

FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis of investment decisions. To know how to read our weekly fund reviews, please click here.