Last one year has not been good for debt mutual fund investors. Interest rates, after declining for nearly three years bottomed out in the middle of 2017, have been on an upward trajectory since then. While, long term gilt funds, income funds etc, which invest in long dated bonds have been the worst affected; even short term debt funds gave disappointing returns in the last one year. A couple of days back, the bond market rallied as the Government announced reductions in its borrowing plans, but near to medium term concerns remain. So far the Reserve Bank of India has maintained status quo on interest rates, as it does not see, risk to inflation target in the immediate term.
United States Federal Reserve policy decisions will impact all bond markets in the world, including India. The most immediate impact of interest rate hikes in the US, as far we are concerned, is on the rupee. We are a net an importing economy – when the rupee depreciates, our current account deficit and fiscal deficit will rise. Rising crude prices and weakening rupee make fiscal deficit and inflation a concern. On the domestic front, it is still not very clear, how the Government plans to fund the Prime Minister’s ambitious Medicare scheme. Decline in vegetable prices may give RBI the space to hold the repo rate in its April meeting. But the outlook in the medium term is uncertain.
The banks have recently raised fixed rates across various tenures. The rates in the 1 to 3 year tenures are in the range of 6.5% to 7.2%, which on a post tax basis is still lower than what retail investors usually expect. While the Government Small Savings Scheme’s interest, are slightly higher than bank FD rates, they are in the range of 7.3% to 7.6%, which is much lower than average rates over the last 5 to 7 years. Further, despite the banks raising FD rates earlier this month, the Government Small Savings Scheme’s interest rates are likely to remain unchanged in the coming quarter.
Low risk free (FD and Government Small Savings Schemes) interest rates and bond market volatility affecting debt fund returns is likely to be a cause of concern for fixed income investors. Mutual funds can provide a solution for investors looking for higher income at low to moderate risk. In the last one year, while long term debt funds gave 3 to 4.7% returns, short term debt funds gave around 6% returns and money market mutual funds (liquid and ultra-short term debt funds) gave 6.3% – 6.7%, credit opportunities funds were the big outperformers – Credit Opportunities funds on an average gave around 7% or higher returns in the last 1 year. Over the last three years, Credit Opportunities Funds were the best performing debt fund products giving north of 8% compounded annual returns.
In uncertain or adverse interest rate environments, good Credit Opportunities funds can provide good income solutions to investors, provided they understand the risk factors involved in these investments. In my various interaction with investors, as well as based on the queries and comments we receive from investors in Advisorkhoj, I have seen that retail investors in general have limited understanding of debt funds. Credit Opportunities funds are among the most misunderstood product categories within the debt fund asset class. In this blog post, we will discuss about Credit Opportunities funds in general and ICICI Prudential Regular Savings Fund, a good Credit Opportunities fund, in particular.
What are Credit Opportunities Funds?
Credit Opportunities Funds are a type of short term debt mutual fund. Residual maturities of securities in short term debt fund portfolios are usually in the range of 2 – 3 years; Credit Opportunities funds have similar maturity profile. What is the difference? Short term debt mutual funds have substantial allocations to Government Bonds, whereas Credit Opportunities funds invest almost all their assets in Non Convertible Debentures or Corporate Bonds. ICICI Prudential Regular Savings Fund is invested entirely in NCDs.
The corporate bond market in India is still underdeveloped and there is not enough supply to meet investor demand; hence most debt funds invest primarily in Government Bonds. However, this market is growing, as banks saddled with Non Performing Assets (NPAs), are wary of lending money. In the last fiscal year corporate bond sales surged 40%. Though this market caters primarily to institutional investors, informed retail investors can tap the NCD market through Corporate Bond mutual funds or Credit Opportunities fund to get good returns in the medium term. Let us now discuss what NCD is.
What are Non-Convertible Debentures (NCD)?
These are debt securities or bonds issued by public sector or private sector companies. Debentures are unsecured bonds, which means that, they are not by a physical asset or collateral. Remember, Government Bonds come with sovereign guarantee, which means they interest and principal re-payment is assured by the Government. There is no such guarantee in NCDs, which means there is a risk involved in such an investment. What do NCD investors get in return for taking more risk? NCDs pay a higher rate of interest (coupon) compared to Government Bonds. If NCDs are held till maturity, assuming no default, they will give higher returns than Government Bonds of similar maturities.
Credit Opportunities fund managers aim to capture the higher yields of corporate bonds to give superior returns to investors, while endeavoring to minimize risks for the investors at the same time. The yield to maturity of ICICI Prudential Regular Savings Fund is 9.9% which means that, the NCDs in the scheme portfolio will give 9.9% annualized returns if the NCDs are held to maturity – this is significantly higher than what Government Bonds will yield. Please note however that, the YTM will not be equal to scheme returns because expenses will have to deducted (ICICI Prudential Regular Savings Fund has an expense ratio of 1.7% of assets) and YTM may change, as the portfolio changes due to inflows and redemptions.
Nevertheless, the yields of Credit Opportunities Funds will be significantly higher than Gilt Funds or short term debt funds which invest primarily in Gilts (Government Bonds) of similar maturity profiles. In our blog, we have often discussed the fundamental relationship between risk and returns in investments. So what is the nature risk for which we get additional returns in Credit Opportunities fund?
Risk in NCDs
Regular readers of our blog will know that, debt mutual funds are subject to interest rate risk – if interest rates go down bond prices rise, debt fund returns are higher and vice versa. Most of the discussion of debt fund risk factors is centered on interest rate risks because most debt mutual funds invest primarily in Government Bonds. Interest rate sensitivity of a bond is proportional to the maturity of the bond - longer the maturity, higher is the interest rate risk. For debt mutual funds of shorter duration e.g. money market mutual funds, short term debt mutual funds, credit opportunities funds etc, the interest rate risk is limited.
The average maturity of ICICI Prudential Regular Savings Fund is 1.91 years. So for 25 bps change in interest rates, the average price of the NCDs in the scheme portfolio will change by 0.48%. If interest rates go up by 25 bps during the year, the returns will come down by 0.48% during the same period and vice versa. However, if the NCDs are held till maturity, then interest rate changes are not a factor because the investor will get the face value of the NCD at maturity. Credit Opportunities fund managers usually employ hold till maturity or accrual strategy. Therefore, if you align your investment tenure with the maturity profile of the fund, then interest rate risk is quite limited. Let us now discuss the other, more relevant, risk factor for Credit Opportunities fund.
In addition to interest rate risk, the other relevant risk factor for debt funds is the credit risk. Credit risk is the risk of non-payment of interest or principal by the bond issuer. Credit risk differs from NCD to NCD and from one Credit Opportunities fund to another, depending on the credit risk strategy of the fund manager. How can investors know about credit risk?
Debt securities, issued by NCD issuers / companies, are rated by independent credit agencies like CRISIL, ICRA etc. Credit rating is a measure of credit risk or risk of default. Higher the credit rating, lower the credit risk and vice versa. The interest rate or coupon or yield of the NCD will be inversely proportional to the credit rating. If an NCD is rated lower, it has to offer higher interest rate to investors, while an NCD which is rate higher, can pay lesser interest rate. The table below describes the credit rating scale used by CRISIL to rate debt securities.
Source: CRISIL Credit Rating
I have noticed that, some investors do not have a good understanding of credit ratings – some investors think that bonds rated below AAA are risky. You can see in the table above that, AAA denotes highest safety, but NCDs rated BBB to AA also have varying degrees of safety. In order to get higher yields (returns), fund managers may invest in slightly lower rated but still investment grade papers - the yield to maturity of ICICI Prudential Regular Savings Fund is higher than average corporate bond funds. Please note that, NCDs rated BBB and above are considered investment grade. The average credit rating of ICICI Prudential Regular Savings Fund portfolio is BBB; so the credit rating profile of the fund portfolio is definitely investment grade.
Apart from higher yields and limited interest rate risk, the other advantage of Credit Opportunities fund is that, if the credit rating of a lower rated NCD in the fund portfolio gets upgraded then the price of the NCD will rise and the fund will give higher returns. The flip side is that, if an NCD gets downgraded then the price of the NCD will fall. In the media, the focus is more on ratings downgrades, but in reality ratings upgrades are as common, if not more common, than ratings downgrades.
ICICI Prudential Regular Savings Fund was launched in December 2010. The scheme has more than Rs 9,000 Crores of Assets under Management. The expense ratio of the scheme is 1.7%. The fund has give 8.81% returns since inception. The chart below shows the annual returns of the fund over the last 5 years.
In this blog post, we have discussed about how Credit Opportunities fund can offer investment solutions for investors looking for higher incomes in the current interest rate environment. Investors must understand the risk factors of the fund, particularly credit risk before investing. Investors should avoid funds, which have a high percentage of papers rated BBB- or lower. Investors can consult with their financial advisor, if ICICI Prudential Regular Savings Fund is suitable for their investment needs.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.