Credit risk funds: risking too much for too little?

Credit Risk Funds

Mutual funds are subject to market risks—a known disclaimer to all mutual fund investors. But, unless investors taste the risks themselves, they don’t realise how important is it to analyse the risk profile of mutual fund schemes before investing.

Until recently, it wasn’t common to hear that investors of debt funds lost money. But nowadays, Net Asset Values (NAVs) of debt funds fall like those of equity funds.

Reason?

Default risk has suddenly started making a frequent appearance, especially, ever since the Lehman Movement of India (IL&FS crisis) unfolded.

This article is an attempt to make investors realise how real the default risk is.

Amongst various categories of debt funds, credit risk funds are the only category that overtly spells out the risk it exposes investors to. Nonetheless, investors trust fund managers (perhaps blindly) for their skills, wisdom and integrity.

As the name suggests, credit risk funds are expected to accelerate returns by taking measured risks. According to AMFI data published on April 30, 2019, credit risk funds had an asset base of Rs 79,644 crore. Assets under Management (AUM) of debt funds, excluding that in overnight funds, liquid funds and ultra-short duration funds, was Rs 5,12,043 crore. In other words, credit risk funds accounted for 15.6% of income funds.

They are quite popular among investors, aren’t they?

There are 5,76,015 unique folio accounts held in credit risk funds across 20 schemes.

As per SEBI categorisation norms, credit risk funds must invest 65% of their total assets in instruments rated below the highest rated instruments. In plain English, they must hold 65% of their portfolio outside AAA and A1 rated instruments.

But do you ever bother to check, where credit risk funds actually invest?

Rating profile of credit risk funds…

Credit Risk Funds

Data as per portfolios disclosed on March 29, 2019

Source: ACE MF

They are not only investing in unrated instruments but also in companies wherein the investment rationale appears inexplicable, at least on the face of it. Credit risk funds have high exposure to companies belonging to troubled sectors— Power and Construction.

Now answer this question only with your common sense.

Would you invest in zero coupon bonds issued by a private limited company that was incorporated in January 2018?

To top it, would you lock in 2.76% of your investable corpus in such a company until April 2021? Once acquired, instruments issued by lesser-known, unrated companies are difficult to get rid of.

Perhaps, Reliance Credit Risk Fund thinks otherwise. It’s invested in an unrated zero-coupon instrument issued by Vineha Enterprises Private Limited, which got incorporated in January 2018.

And that’s not all. Reliance Credit Risk Fund has invested 8.7% of its assets in a lesser known company; RMZ BuildconPvt Ltd. ICRA has assigned the BBB+ rating to the Structured Obligation (SO) of this company. Again, like Vineha Enterprises, this company got registered only recently (On May 28, 2018) according to ET database.

A note was written by ICRA to justify its ‘rating rationale’ for RMZ Buildcon will shock you.

Credit Risk Funds

Black box accounting at play?

And let’s not blame Reliance Credit Risk Fund.

Its peers are no better.

HDFC Credit Risk Debt Fund has invested 1.87% of its assets in DB Consolidated Pvt Ltd.—an unlisted promoter group company of D.B.Corp Ltd.

According to ET Database, DB Consolidated Pvt Ltd. is chiefly involved in the trading business. This company, according to ET Database, held its last AGM on September 29, 2017, and updated its balance sheet on March 31, 2017. As per the story published by Business Line dated March 28, 2019, DB Corp Ltd. amalgamated Stitex Global Limited (one of the promoter group companies) with DB Consolidated Pvt Ltd.

Reading between the lines doesn’t paint a rosy picture.

Are debt funds risking too much to fund promoters through complex structures?

No lessons from the IL&FS and the Essel group debt debacles? It looks like that.

Take one more example.

ICICI Prudential Credit Risk Fund has invested 1.4% of its AUM in the commercial paper issued by Jindal Steel & Power (JSPL). If you remember, this company has a history of defaults. In 2016, JSPL defaulted on the interest payment on its Non-Convertible Debentures (NCDs). The spokesperson of the company had blamed the short term cash flow mismatch for this default.

Fast forward to 2019, the commercial paper of the company is still rated BBB-, a minimum rating required to be classified as the investment grade instrument.

BOI AXA Credit Risk Fund seems to have crossed all limits. It holds 28% of its assets in unrated debt securities.

Now let’s see if the returns are commensurate with the risks credit risk that funds take.

Credit risk funds have generated compounded annualised returns ranging from 4.4% to 7.9% over the last three years. The corresponding returns don’t justify the risks debt funds take.

Credit risk funds: a high risk-low return proposition…

Credit Risk Funds

Data as on May 10, 2019

(Source: ACE MF)

Now let’s go back to the basics and check if credit funds have any merit…

Investing in credit risk funds makes sense only when the credit environment in the country is stable and expected to improve. As you would know, rating upgrades cause a rally in bonds. In contrast, under a hawkish credit environment—when the downgrades outnumber upgrades, it’s better to stay away from chasing yields.

Unfortunately, the reverse of this happened post demonetisation. Investors chased returns underestimating risks. And, fund managers chased yields disregarding the risk of default.

Moral of the story…

In a famous Hindi movie—Rowdy Rathod, a police commissioner advises ACP Vikram Rathod not to underestimate risks, instead of respect them. Investors can only hope that the top bosses of the mutual fund industry would offer the same advice to fund managers of debt funds.

After all, disclaimers can only save them from potential legal suits. The loss of reputation and trust is the real risk debt funds face today.

Disclaimer: Ventura Securities Ltd has taken due care and caution in compilation of data for its web blog. The information has been obtained from different sources which it considers reliable. However, Ventura Securities Ltd does not guarantee the accuracy, adequacy or completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. Ventura Securities Ltd especially states that it has no financial liability whatsoever to any user on account of the use of information provided on its web blog. The information provided herein is just for the knowledge purpose and shouldn’t be construed as investment advice under any circumstances.

 

Leave a Reply