Should Investors Fear Debt Funds Taking Credit Risk?

In October 2008, fixed maturity plans (FMPs) were in the news for all the wrong reasons. The financial crisis had set in, and equity markets had crashed.

Debt markets weren’t spared either: it was feared that papers issued by some real estate and broking firms, among others would default. Several debt funds, including FMPs were heavily invested in such instruments. Amidst tight liquidity, there was a run on fund companies, which in turn led to distress sales, and net asset values (NAVs) crashing. The latter fuelled more panic, and further distress sales.

Roughly nine years hence, I see a similar narrative playing out in the context of debt funds taking credit risk. Admittedly, the level of fear isn’t even remotely comparable as yet, but make no mistake, the narrative is similar.

Every time a credit rating agency downgrades the rating on an instrument, it makes headlines. Media lists which mutual fund portfolios hold the downgraded paper, alongside the allocation. Words such as default and loss are liberally tossed around, leading to fund investors hitting the panic button.

So should investors fear debt funds that take credit risk? Let’s find out.

The strategy of taking credit risk (or high-yield investing) entails investing in securities with a lower credit rating. Such instruments offer a higher coupon rate (versus securities with a higher credit rating). Furthermore, there is a possibility of the price appreciating if the credit rating is upgraded.

Does this investment strategy involve risk—indeed, it does. There is risk of the issuer defaulting on the payment of interest and/or the principal. Often such bonds can be illiquid which further accentuates their risk profile.

Given the risk, should investors shun funds using a credit risk-based strategy? No, and here’s why: The strategy of taking credit risk is as legitimate as any other. Several portfolio managers (both in India and globally) have plied it successfully and delivered pleasing long-term results. A strategy doesn’t become faulty simply because it entails risk.

Some experts argue that investors should only invest in debt funds deploying the duration strategy. That’s a weak argument because failing to read the direction in which interest rates will move, can also lead to losses. A case in point is the performance of debt funds in February 2017, when contrary to expectations, RBI kept policy rates unchanged.

Also, this is a case example of missing the woods for the trees—mutual fund investing is not without risk. Sure, some strategies are riskier than others, but risk is omnipresent.

Investors will do themselves a huge disservice by treating debt funds with a credit strategy like pariahs, and hitting the panic button in reaction to every news story. Instead, a prudent approach will be to acquire an unambiguous understanding of the risk involved, and then decide if they are comfortable taking on the same.

It's worth noting that when investment decisions are based on a combination of fear and ignorance, the results can be rather unpleasant.