Should you avoid debt funds due to credit risk?

Zafar is a retired investor who considers equity risky and fixed income instruments or debt mutual funds safer bets. However, recent news of some corporates defaulting on bond interest payments and repayments have forced him to rethink his stance on debt mutual funds. The sudden focus on credit risk is making him jittery. He wonders if he should redeem his debt fund investments and put them in government saving schemes.

Zafar must understand that not all debt funds are risky and will give negative returns and not all corporate bonds will default. Credit risk (risk of default arising from exposure to debt instruments of companies that do not have top credit quality) is a function of the conscious decision-making of a fund house and therefore, does not affect all funds. It is also wrong to assume that all debt funds take the same amount of risk, with regards to credit quality.

While a corporate bond opportunities fund may have a high exposure to A-rated securities, an income fund may have a high allocation to AAA-rated bonds, implying the highest credit quality. The risk of default increases linearly with each move down the credit curve— AA, A, BBB and so on. Fund houses use these ratings and their internal due diligence before taking a call on which security to invest in.

Zafar must also note that a firm with a low credit rating often compensates investors by offering a higher coupon. Typically, corporate bonds rated AA and below offer coupons that are at least 1.5-2% higher. This enhances the overall portfolio yield for the investor.

Therefore, Zafar must examine the portfolio of the funds that he has invested in to check whether the fund has taken a high credit risk in order to deliver the slightly superior return. A default causes a downgrade of credit rating for the security, leading to a fall in its market value, which translates into a loss for the fund. Further, a default on a low-rated paper could turn the security illiquid, causing further losses to the fund.

Investors like Zafar must do their own due diligence, both before and after investing. Information on credit rating of holdings is available in fund fact sheets. He must evaluate the fund based on his risk tolerance.

Unless he is willing to undertake the risk attached to high yield and credit opportunities strategies, he must stay clear even if it means giving up that superior return. If he is uncomfortable with the related risk, he must realign his investments towards funds with a top quality credit rating.

(Economic Times)