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What you must consider before investing in credit funds

28 Jun 2023

Credit funds went through a lull phase after the case of J P Morgan Fund which got stuck due to the sudden downgrade of Amtek Auto debt. That was back in 2015. However, these funds have again seen a surge of inflows from 2016 onwards as debt fund investors found a good way of earning higher yields in credit funds. Basically credit funds are those that look for credit opportunities in the debt market. What are credit opportunities? Corporate bonds pay higher yields compared to government and institutional bonds. However, even within the corporate bond spectrum, there is a clear demarcation. There are funds that are ‘AAA’ rated which pay the lowest yields. As you move towards 'AA' funds and 'A' funds, your risk profile increases but so do you returns. Credit fund managers look for opportunities where there is underpriced debt which is currently available at higher yields due to their rating profile.


Reverting back to the J P Morgan Case and the Amtek Auto fiasco

J P Morgan debt fund had a huge exposure to the bonds issued by Amtek Auto, a mid-sized auto ancillary company based out of central India. In fact, this was before SEBI had prescribed sector-wise and company-wise limits to debt exposures. Amtek had already been in trouble as some of its global expansion forays had gone awry and its debt was mounting to unsustainable levels. When the first default became public in 2015, the rating agency straightaway downgraded the bond by several notches. When that happened, the price of Amtek Auto debt crashed in the markets and that led to a sharp depreciation in the NAV of the fund. This led to a rush to redeem the funds almost leading to a default by J P Morgan Fund. While the problem did get sorted out with the support from the parent, it did serve to highlight the risks of a credit fund. When you are investing in credit funds what is the debt fund vs credit fund analysis you need to do? Should you invest in credit opportunity funds in the first place? Here are 7 factors to consider..


Factors to consider when investing in credit funds
1.  Suitability of the credit fund to your risk-return profile is the primary consideration. You must not get into credit funds just for the higher returns. You must be clear that it suits your risk profile. If you are a low risk debt investor with a short term frame then credit funds are not for you. You need a higher risk appetite to digest credit funds.

2.  Quality of credit fund and portfolio mix. Not all credit funds are high risk funds. After the SEBI regulations came in, most credit funds were forced to cut down their exposure to NBFCs, which were the largest issuers of bonds in the market. Quality of credit matters. When the fund manager goes down the credit curve, it must not be at the cost of compromising on the quality of the fund.

3.  Focus on lower expense ratio in credit funds. Remember, credit fund yields are falling and they have been consistently falling in tune with the repo rate cuts in the last 3 years. Therefore the expense ratio makes a big difference. Even a 30 basis difference in the expense ratio can make a big difference to the net yield on your credit funds.


4.  Exit loads can add a burden to credit funds too. Most credit funds have multi-year credit loads. That is because credit funds typically want to avoid too much of redemption pressure considering the delicate nature of the assets. When this is added to the expense ratio, the overall cost can be quite high. Factor that also into your calculations.

5.  Check yield advantage in credit funds. This is a very important aspect of credit funds. When you are holding government bond funds, you get the additional benefit of NAV appreciation when rates go down. Credit funds are less about capital appreciation and more about higher yields. You need to take a comparative view before zeroing in on a credit fund.

6.  Keep a tab on rating upgrades and downgrades. In the Amtek case, the credit downgrade was bunched as default information was not forthcoming on time. Now, the situation has been redeemed with the onus on the bank to disclose default information immediately to the regulator. Even otherwise, it makes sense for you as an investor to keep a tab on the ratings and the financial solvency of the debt paper that the credit fund is invested in.

7.  Pedigree of the AMC matters a lot. If the credit fund belongs to a large Indian AMC or the Indian arm of a global giant, then you are much safer. Smaller AMCs may not have the resources or the wherewithal to protect the investor interest with the requisite funding support. That is something you need to be wary of in credit funds.

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