Is it a good time to invest in credit risk funds?

As this report indicates, credit risk funds have room to offer better returns, as spreads between AAA and AA are still attractive, but not as attractive as they were in the aftermath of the Franklin fiasco. Templeton.

On October 5, 2021, Moody’s changed India’s sovereign ratings outlook from stable to negative and maintained its rating at Baa3 for India’s foreign currency, long-term issuer ratings in local currency and rating unsecured senior in local currency. The change in perspective is because they believed the downside risks from negative feedback between the real economy and the financial system were diminishing. As previously anticipated by the rating agency, with capital buffers and greater liquidity, banks and non-banking financial institutions present a much lower risk for the sovereign. Nevertheless, another rating agency, Fitch, has reaffirmed its BBB sovereign ratings on India, which is the lowest investment rating of India’s sovereign rating. Fitch Ratings maintained its negative outlook as it believes India has high public debt, a weak financial sector and some lagging structural issues.

Fitch Ratings has warned that India could suffer a rating downgrade if it fails to reduce the public debt to GDP ratio. Structurally weaker real GDP growth prospects due to continued financial sector weakness or lack of reform implementation could further weigh on the debt trajectory. That said, India is experiencing a rapid economic recovery from the pandemic. Moreover, the pressures on the financial sector are also easing and even the risks are diminishing. Credit institutions expect demand for business loans to rebound by the end of FY22. Indeed, to meet growing demand for goods and services amid renewed economic activities , companies would turn to capital expenditure.

Improving the economy and credit risk funds

For a mutual fund investor looking to invest in debt funds, improving economic growth presents a good opportunity to gain exposure to credit-risk funds. Last year, due to erratic credit events and some headwinds facing the economy, credit risk funds had started to feel the heat long before the pandemic hit. Credit risk funds are a type of debt-focused mutual fund that invests in securities with lower credit ratings, giving them the name “credit risk” funds. Credit risk funds in India are mandated to allocate at least 65% of their portfolio to debt securities rated below ‘AA’.

Investors started to fall out of this category when Franklin Templeton closed its six MF debt programs in April 2020. By October 2021, the fund house had distributed about 88% (Rs 23,999 crore) to investors of the total of Rs 27 333 crore assets under management (AUM) from the six closed plans.

As can be seen, the assets under management of credit risk funds had fallen drastically after the Franklin Templeton fiasco. Even though the AUM there remained stable, net inflows increased from February 2021 and in May 2021, they moved into positive territory. This shows that the interest is gradually increasing for credit risk funds. Institutional investors, who are considered smarter than retail investors and dominate debt-focused schemes (nearly 63% of assets under management), have increased their investment in these funds, as shown in the attached chart . Therefore, the assets under management and the increase in net inflows to credit risk funds give a good idea of ​​what we can expect in the future. In addition, what also favors credit risk funds is better credit drawdown. Although there is no direct relationship between rising credit and credit risk fund returns, better credit growth signals a good economic recovery and lower risk vis-à-vis low-grade paper. rating. In FY22, credit drawdowns improved, with non-food credit growth declining from 5.1% a year ago to 6.8% year-on-year (YoY) on September 24, 2021. This is more evident in the table below.

Credit growth among public sector banks remained modest, while there was some increase in the case of private sector banks which provided the bulk (56.7%) of the additional credit extended by regular commercial banks (SCB) on an annual basis as of September 24. , 2021. Thanks to a favorable monsoon and support measures for the agricultural sector, even public sector banks recorded credit growth on an annual basis in August 2021.

It is quite evident from the graphs above that bank lending to the industry has started to improve and can see good improvement on a yearly basis. Infrastructure credit – which accounts for about 38 percent of industrial credit – also improved, led by roads and airports credit. The main driver of overall industrial credit growth was infrastructure, followed by textiles. Credit growth to the services sector slowed to 3.5% in August 2021, from 10.9% in the same month last year. This can largely be attributed to the slowdown in credit to NBFCs which raised resources primarily in the money and debt markets.

The graph above clearly shows that overall domestic credit growth has improved after hitting a ten-year low of 5.35% in May 2021. Credit growth has yet to reach pre-pandemic levels . However, given the recovery in economic activity, it looks like credit growth will be robust in the near future. The second factor that gives an idea of ​​the performance of these funds is the debt-weighted credit ratio. The credit ratio, calculated in number of upgrades to downgrades, maintained its upward position in the first half of FY22. According to CRISIL, there were 488 upgrades and 165 downgrades for the first half of FY22 . When we calculate the debt-weighted ratio, it shows the debt-weighted credit ratio.

Historically, we have found that there is a positive relationship between the debt-weighted credit ratio and the returns generated by credit risk funds. Over the years 2014 and 2016 we have seen credit risk funds generate double digit returns and it is no coincidence that over these two years we have seen the debt weighted credit ratio improve . In fiscal 2017, we found that although the credit ratio remained stable, the debt-weighted credit ratio reached its highest level in five years. Similarly, in 2014, we saw a marked improvement in the debt-weighted credit ratio, from less than 0.3 to around 0.5.

A rising credit ratio means lower risk and therefore higher return as yield declines and bond values ​​rise. At the end of S1FY22, the debt-weighted credit ratio is above 2, which is a positive sign for these funds. Year-to-date returns for this fund category already give an idea of ​​the returns we can expect from these funds. The following table shows the returns by calendar year for credit risk funds:

On a YTD basis, credit risk funds averaged returns of 8.56%, but there were funds such as UTI Credit Risk Fund, Baroda Credit Risk Fund, IDBI Credit Risk Fund, Franklin India Credit Risk Fund and Nippon India Credit Risk Fund which gave double numerical returns of 20.92%, 18.71%, 15.55%, 12.82% and 12.80%, respectively.

Should you invest in these funds?

In conclusion, we believe that credit risk funds still have room to deliver better returns, as spreads between AAA and AA are still attractive, but not as attractive as they were in the aftermath of the Franklin fiasco. Templeton. We believe this is a bold, risk-taking investor who should invest no more than 10% of their debt portfolio in credit risk funds. Also, this should be included in the satellite wallet and not part of your main wallet. In addition, credit risk funds should be actively managed based on the credit situation and the overall performance of businesses and the economy. So if you understand these nuances, you can always invest in such funds as part of your tactical investment strategy.

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