Investing in bond funds? Understand credit risk first
Taking exposure to low rated bonds mean high credit risk.
Such bonds can impact the liquidity of the portfolio. Also in case of default,
the permanent capital loss cannot be ruled out.
There are various perceptions related to debt mutual funds
scheme and one of the strong one is that they are the safest asset class to
invest. When these schemes are compared to fixed deposit or even savings
accounts investors perceive it to be as safe as them. But that’s not so. Debt
mutual funds have various risk involved pertaining to the securities they
invest in. Yes the risk may be lower or higher in different schemes based on
the type of securities they invest in. Even the safest of the categories liquid
funds have seen negative returns in the past. But that’s a different story to
write about.
In recent times the questions has been raised on portfolios of some debt mutual funds schemes. These schemes have taken exposure in low or unrated securities increasing the inherent risk in the scheme. Whether as an investor this higher risk is justified for your objective is a decision which can be taken only when you understand this risk involved.
Let’s understand this risk and why this is important to be known to you.
Credit risk
A credit risk is probably the most important factor in debt securities. In layman’s terms it is the default risk by the issuer of the security which means that the company who has issued the underlying security can default on their payments to their investors. If this happens then the mutual funds scheme which has invested in such companies will run the risk of not only failing to achieve the desired returns to investors but will also run the risk of the safety of the capital and liquidity of investment too.
How to judge credit risk?
When corporates issue any kind of securities it has to get rated by the rating agencies. A high rating like AAA or P1+ will signify that the company does have sound financials and so have a minimal risk of default while a low rating like A or below will signify a higher probability of default. Low rated security will offer you higher returns as compared to their high rated counterparts, but will also carry higher risk. Some securities remain unrated and so may offer the highest payouts but come with highest risk.
Debt mutual funds scheme invests in different types of securities based on the scheme’s objective. Since the level of exposure varies among schemes the performance also then varies. Any scheme which wishes to generate higher returns will skew its portfolio towards low rated papers. Contrary to this schemes which take more exposure in high rated securities may not deliver higher returns but will offer lower risk to its investors.
If you analyze the portfolio of different ultra-short term schemes then you will find difference in level of exposure to debt securities. For instance Reliance money manager does not take exposure in securities below AA ratings and is almost 70-75% invested in AAA and P1+ companies which are highest rated securities. Contrary to this Franklin Templeton Ultra Short-term Bond Fund has approximately 21% investment in A and below rated securities along with 60-70% exposure in AAA and P1+. Birla Sun Life savings fund and ICICI prudential Flexible income plan have some exposure to low rated papers and level of such exposure differs from each other. This difference of exposure surely brings deference in the returns which are visible in their performance. But on other side these scheme will also have different level of credit risk in their portfolio. So, by analyzing the portfolio of a debt mutual funds scheme you can make an initial note what you should be expecting from the scheme you have chosen.
What investors should do?
The risk and return go hand in hand. Before investing in any scheme you have to carefully look at its portfolio. Looking at the composition of the portfolio you can at least get a glimpse of the risk involved. Funds like liquid or ultra-short term schemes are made for high liquidity and lowest risk. If such schemes take higher credit risk, both the safety and liquidity can be compromised. It may be the fund manager’s call who may be targeting to deliver higher returns by taking more exposure in low rated papers. Now you need to decide whether this objective matches with yours. If not then you are better off investing in schemes which focus more on liquidity by keeping this risk low in their portfolio even if it end up delivering a bit lower return in comparison to its peers.
At times it is bit more difficult to analyze a debt fund as compared to an equity fund. But it pays to keep a track of credit risk of a debt fund portfolio. Do not chase high returns ignoring the risk involved.
In recent times the questions has been raised on portfolios of some debt mutual funds schemes. These schemes have taken exposure in low or unrated securities increasing the inherent risk in the scheme. Whether as an investor this higher risk is justified for your objective is a decision which can be taken only when you understand this risk involved.
Let’s understand this risk and why this is important to be known to you.
Credit risk
A credit risk is probably the most important factor in debt securities. In layman’s terms it is the default risk by the issuer of the security which means that the company who has issued the underlying security can default on their payments to their investors. If this happens then the mutual funds scheme which has invested in such companies will run the risk of not only failing to achieve the desired returns to investors but will also run the risk of the safety of the capital and liquidity of investment too.
How to judge credit risk?
When corporates issue any kind of securities it has to get rated by the rating agencies. A high rating like AAA or P1+ will signify that the company does have sound financials and so have a minimal risk of default while a low rating like A or below will signify a higher probability of default. Low rated security will offer you higher returns as compared to their high rated counterparts, but will also carry higher risk. Some securities remain unrated and so may offer the highest payouts but come with highest risk.
Debt mutual funds scheme invests in different types of securities based on the scheme’s objective. Since the level of exposure varies among schemes the performance also then varies. Any scheme which wishes to generate higher returns will skew its portfolio towards low rated papers. Contrary to this schemes which take more exposure in high rated securities may not deliver higher returns but will offer lower risk to its investors.
If you analyze the portfolio of different ultra-short term schemes then you will find difference in level of exposure to debt securities. For instance Reliance money manager does not take exposure in securities below AA ratings and is almost 70-75% invested in AAA and P1+ companies which are highest rated securities. Contrary to this Franklin Templeton Ultra Short-term Bond Fund has approximately 21% investment in A and below rated securities along with 60-70% exposure in AAA and P1+. Birla Sun Life savings fund and ICICI prudential Flexible income plan have some exposure to low rated papers and level of such exposure differs from each other. This difference of exposure surely brings deference in the returns which are visible in their performance. But on other side these scheme will also have different level of credit risk in their portfolio. So, by analyzing the portfolio of a debt mutual funds scheme you can make an initial note what you should be expecting from the scheme you have chosen.
What investors should do?
The risk and return go hand in hand. Before investing in any scheme you have to carefully look at its portfolio. Looking at the composition of the portfolio you can at least get a glimpse of the risk involved. Funds like liquid or ultra-short term schemes are made for high liquidity and lowest risk. If such schemes take higher credit risk, both the safety and liquidity can be compromised. It may be the fund manager’s call who may be targeting to deliver higher returns by taking more exposure in low rated papers. Now you need to decide whether this objective matches with yours. If not then you are better off investing in schemes which focus more on liquidity by keeping this risk low in their portfolio even if it end up delivering a bit lower return in comparison to its peers.
At times it is bit more difficult to analyze a debt fund as compared to an equity fund. But it pays to keep a track of credit risk of a debt fund portfolio. Do not chase high returns ignoring the risk involved.
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