With inflation turning sticky and both the US Fed and India’s Monetary Policy Committee looking to rely on incoming data for future rate decisions, there’s considerable uncertainty about the timing of rate cuts. Meanwhile, Indian bonds are seeing rising foreign participation on the back of their inclusion in global indices. These two factors are holding back the performance of debt funds that depend on duration for returns.
For investors who wish to avoid these uncertainties, debt funds using accrual strategies are a better bet. Credit risk funds, which invest at least 65 per cent of their portfolio in corporate bonds rated AA or below, offer a shot at high accrual returns. Bonds rated AA are currently trading at spreads of 150-200 basis points over the one-year treasury bill yield of 7.08 per cent. Though credit risk funds carry default risks, the macro environment is currently conducive for such funds. Debt levels of Indian companies are at historic lows, while their debt servicing abilities are strong.
However, credit risk can be a dicey category to navigate, with the possibility of sudden write-downs in value due to defaults as well as liquidity issues that are inherent in lower-rated corporate bonds. Therefore, when choosing funds, it is best to choose the ones with low concentration of holdings, competitive fees and a track record of avoiding big defaults. ICICI Pru Credit Risk Fund fits the bill and can be considered by investors.
Why buy
Portfolio yield to maturity (YTM) provides a good indicator of the likely returns from a debt fund. With a YTM of 8.75 per cent by end-March, ICICI Pru Credit Risk Fund featured a portfolio yield that was well above the category average of 8.35 per cent. This is a reflection of the fund owning a significant exposure to lower-rated corporate bonds. As per the latest factsheet (April 30, 2024), the fund had a 53 per cent exposure to corporate bonds rated AA and a 14 per cent exposure to bonds rated A. This compares to the category average of about 60 per cent in AA-rated bonds and 5 per cent in A-rated ones.
But the fund attempts to balance out the high risks from its holdings in lower-rated corporate bonds through three means. One, it owns a 14 per cent sovereign bond exposure as well as exposures to hybrid instruments such as Real Estate and Infrastructure Investment Trusts (REITs and Invits). Two, it owns a much more diversified portfolio than peers. The top-five corporate bond holdings of the ICICI Pru Credit Risk fund accounted for 3-3.8 per cent each of its assets. Whereas, the top holdings for peers such as Nippon Credit Risk Fund make up 4.5-7 per cent of assets. Three, the fund minimises duration risk by maintaining an average maturity of about three years.
Many debt funds owning lower-rated bonds have suffered defaults and taken NAV write-downs, when the credit or liquidity environment for bonds has turned hostile. Funds faced with such defaults have carved out the doubtful bonds into side-pockets, which dent the NAV. ICICI Pru Credit Risk Fund is among the rare debt funds with lower-rated bonds to have completely avoided side-pocketing or large defaults, so far.
This is also reflected in the fund’s rolling returns for the last 10 years showing a minimum one-year gain of 4.5 per cent, with zero loss-making periods. The fund’s returns have fallen in the 5-10 per cent range about 65 per cent of the time and 10-20 per cent about 34 per cent of the time, with one-year returns averaging 8.9 per cent.
Credit funds as a category charge expense ratios of between 1.18 and 1.71 per cent on regular plans and 0.28-1.15 per cent on direct plans. However, the large asset size of ICICI Pru Credit Risk Fund ensures that its expense ratio of 1.56 per cent for the regular plan and 0.84 per cent figure in the middle of the category.
Suitability
Unlike duration funds where risks from rate movements are visible every day, credit funds harbour hidden risks which may not become evident until a downgrade, default or liquidity crisis hits. This fund is therefore suitable for investors with a high risk appetite and ability for hold for five years plus.