Here’s why I don’t invest in credit funds

In our earlier post here we figured out that:

In credit funds, the real issue is not about credit risk , it’s about liquidity risk !!

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Long term investors have to focus on the trade off  between – Expected returns vs Risk

There are two fund management organizations – IDFC MF and Axis MF, who have also communicated their views on credit funds. Let’s read them and see if we can get some additional perspectives.

You can read IDFC fund manager Suyash Choudhary’s thoughts on Credit risk here

Photo_Suyash_Choud_2554466e.jpg

  1. The Macro Reason to Reassess Credit Risk – Link
  2. Managing risks in investment – Credit vs Duration  – Link


Highlights from the note

  1. Long term investors have to focus on both expected return as well as risk when investing
  2. Since this trade-off can always change with changing triggers, the focus should be on expected return versus manageability of risks taken.
  3. Credit risk and duration risk are both legitimate means to earn ‘excess’ returns over fixed deposits
  4. Duration Risk:
    • Duration risk works via a daily mark-to-market channel and hence offers more short term volatility in return profile (although the longer term profile may actually be much more stable)
  5. Credit Risk:
    • Credit risk is binary in natureeither manifests or it doesn’t. This is especially true in a market like ours where there is hardly any secondary market price discovery for lower rated credit assets. Thus change in credit quality doesn’t get dynamically reflected in price changes
  6. The difference really lies in the ability to respond in terms of curtailment of risk if the view changes on evolving developments
  7. Duration risk can be managed on an ongoing basis since it is backed by a robust secondary market where one can buy and sell.
  8. Credit risk cannot be managed on an ongoing basis which makes the ongoing management of the risk difficult.
  9. Also, the relative choice (of how much of credit risk and duration risk to take) has to take into account the macro environment which either creates a tailwind or a headwind to each type of risk
      

You can read Axis fund manager Sivakumar’s thoughts on Credit risk here

Sivakumar_jpg_2431109f.jpg

  1. Credit Issues in Fixed Income Portfolios – Link
  2. Credit Quality – Link
  3. Video – Link

Highlights from the note

  1. Effect of credit default is lumpy and is not captured in daily mark to market. Thus the risk is not captured completely until a downgrade / default event
  2. Apart from the credit risk concerns, the other reason that credit portfolios face a significant risk is the lack of liquidity in the secondary market in lower-rated instruments. This presents a contagion risk for the markets since in case there is a need for any investor to liquidate its portfolio over a short notice, it will be exceedingly difficult to do so.
  3. Understand the credit profile of the fund before investing
  4. Concentrated portfolio increases impact of credit event (i.e downgrades & defaults) – Affects a large part of concentrated portfolio
  5. Not launched credit fund + Conservative approach to credit + Disciplined portfolios with tightly defined limits for most of our funds – >75% AAA – <2% per issuer AA- and below + Relatively liquid portfolios

Parting thoughts:

The above views from these two fund managers, confirm our concerns on credit funds especially on the “liquidity” risk.

Given the above arguments and if you agree with me on the liquidity concerns underlying credit funds then:

Stick to funds with high credit quality

As earlier stated, I personally tend to avoid credit risk in my debt fund portfolios.

I also derive far more comfort on the credit quality when it comes to Axis and IDFC debt funds because they share similar views as mine with regards to credit funds. And the best part is these guys communicate regularly, which also helps us understand their investment strategy. This is precisely the reason why you would have seen me include their funds in our debt selection here

That being said, the above notes from the two fund houses were provided purely with the intent of improving our understanding and by no means do I have any connection with them. While I may have a personal preference towards these two, there are obviously other major fund houses, which also have several funds with high credit quality and you are free to choose whichever suits you the best.

As always happy investing..Cheers 🙂

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

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Author: Arun

Hey! I'm Arun and I work for the research team of a boutique wealth management firm based out of Chennai. The idea behind this space is to share my learnings/mistakes and hopefully help people in making better investment decisions :)

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