Debt defaults hit credit-risk fund returns

Credit-risk funds, which were the top performers among debt funds barely a year back, are now sitting at the bottom of the performance charts. These funds fetched a measly 5% average return over the past year — lower than ultra-short duration funds — compared to return of up to 8% a year ago. The returns from these funds have been singed amid the fallout of the IL&FS default and the spate of credit events that have followed since.

Credit spreads — the difference between the yields of corporate bonds and government bonds — have widened in the wake of the recent credit events. The differential is among the highest since the 2008 financial crisis, data from Bloomberg show. Most credit risk funds hold bonds rated AA and below, where yields have spiked sharply. Bond yields and bond prices move in opposite directions. A handful of credit risk funds had invested much lower down the credit ladder, which yields higher return but also carries higher risk of default. Vidya Bala, head – mutual fund research at FundsIndia, points out: “The top-performing funds which had taken exposure to risky papers magnified the category return earlier. The same funds are now facing the heat from defaults.” She further points out that the concentrated nature of exposure across papers from the same corporate group have had a ripple effect in some fund portfolios.

Experts point out that buying has been concentrated in government bonds and high-grade AAA corporate papers. “While the higher quality credit funds have seen markto-market gains owing to the shift towards higher grade papers, riskier bond funds have taken a hit,” suggests R Sivakumar, head – fixed income, Axis Mutual Fund. “Credit risk funds are now only earning the carry (interest rate on the underlying bonds),” explains Lakshmi Iyer, CIO-fixed income & headproducts, Kotak Mutual Fund. “Once the dust settles in the bond market, the mark-to-market gains will eventually come through for credit risk funds,” she adds.


The moderation in returns is in stark contrast to the high YTM most credit risk funds carried a year back. Some funds were exhibiting greater than 10% YTM in their portfolio. YTM of a credit fund portfolio, adjusted for the expense ratio, is often considered indicative of the actual return it is likely to fetch. However, the weak return profile shows that the higher YTM has not translated into actual return.

Experts maintain investors should not read too much into the YTM profile of the debt fund. Sivakumar argues, “YTM of a debt portfolio is a weak indicator of return. Often, the highest yield fund is not the best performer in the category.” Even today, a few credit risk funds carry yield higher than 10%. Bala insists that investors should be cautious about investing in high yield credit risk funds as the quality of the portfolio may be poor. “Investors should be wary if YTM for a credit risk fund is far above its category average,” she adds. Some fund managers are now exhibiting caution and moving towards higher grade papers, evident from the comparatively lower yield-to-maturity (YTM) profile.