Credit risk funds structurally still have the potential to offer excess returns over market returns

Fixed income investors have been going through uncertain times. Investors in fixed maturity plans of two mutual funds have not been paid in full on the due dates. Elevated credit risk has made many investors shun credit risk funds despite attractive yields.

Bond markets are staring at the outcome of the general elections as it will also have some bearing on the macro-economic factors such as fiscal deficit and government borrowing.

At this crucial juncture, R Sivakumar, Head- Fixed Income, Axis Mutual Fund advises investors to keep their cool. He advises investors not to shun bond funds altogether and instead choose diversified bond portfolios that suit one’s investment needs.

Investors are now officially scared of debt funds. Even liquid funds and FMP have lost money. Can we now say that if you can stomach the risk and stay here for the long run, then invest in equity funds? For everything else, go to bank fixed deposits and non-convertible debentures

The problem is with one or two issuers. Accordingly, a few bond fund schemes are affected. However, there are hundreds of mutual funds schemes out there which are not affected. We should not broad brush the entire system saying every scheme is at risk or every type of category of bond schemes are at risk.

There are a certain number of categories like credit risk funds which come with a lot of credit risk. In the past, we have got the maximum inflows in the credit risk funds in debt fund industry. But when the credit event takes place that comes as a shocker. A few such events in a few funds is not reflective of what is going on in the rest of the system.

Even within fund houses where such events occur, a few specific schemes are getting affected and the majority of the funds are doing good. If we look at last three years performance of the schemes, where credit events took place, the numbers don’t seem to be affected all that much. It’s very easy to look at a very short period of stress and then say that this is going to be repeated every year. I don’t see that happening.

In aggregate, the credit environment across the corporate sector is actually getting better. There are as many upgrades as downgrades over the past couple of years. We are not going through systemic deterioration like we saw in the period of non-performing loans problem two years back.

If the environment is improving, how do you advise investors to pick and choose the right funds?

There are so many ways that you can mitigate these risks. Investors must understand that there is a difference of around 75 to 100 basis points between the rate of interest offered by AA-rated security and AAA rated security. In three year time period, the investor expects around three percentage points absolute excess returns in a portfolio comprising AA rated bonds over a portfolio comprising AAA-rated bonds. In such AA portfolio if a credit events knocks off two to three percentage points, then the excess return is knocked off. The scheme does not offer negative returns, even in case of a credit event. There are two things one should take home – first over one, two or three years time frame investors have not lost money. Second thing investors must understand that if there is a credit event, the excess returns are lost and investors would take home the returns that would be offered by a relatively safe portfolio comprising AAA bonds. However, this is not acceptable. Investors must be compensated for the extra risk they take.

To achieve this, we work backwards. If there is a credit event and one sees a loss of around 25% of the money invested, then what would be the impact on the overall portfolio? To keep that impact to a manageable level say around 0.25% or 0.5% of the net asset value (NAV), we prefer to build a diversified portfolio. If a portfolio has invested 10% of the money in one issuer and then it losses 25% of the money, then the impact on the NAV is 2.5%. That is where it hurts. But if I start with a 2% exposure per issuer and then lose 25% of the money, then the overall impact is half a percentage point of NAV.

As a philosophy, we run an extremely diversified portfolio. Our credit risk fund has more than 50 issuers. Even if one of these issuers face problem, the impact is minimal.

Investors can use this strategy while building their bond portfolios. Invest in schemes of two or three AMCs having diversified portfolios. If you can identify some such schemes offering well-diversified portfolios and there is not much overlap, you will do well. Remember you should be investing less money per issuer when the risk goes up. Do check how much is allocated to AAA, AA and A-rated bonds. More money to AA and A-rated bonds simply means that you are investing in a high-risk portfolio.

You have so far managed to stay away from credit event, barring this diversified portfolio strategy what has worked for you?

Credit risk will always be there in your bond portfolios. You cannot wish it away. What you can do is to manage it better. Keep aside banking and PSU bond fund, our exposure to issuers are capped at 5% in case of AAA-rated issuer. In case of AA and A rated issuers, we restrict our investments to 3% and 2%. We avoid going below A rated securities. We do not invest in unrated securities. Our yield to maturity (YTM) is typically lower than the industry average. High YTM simply connotes high-risk appetite.

We do not take external ratings on the face value. For us, ratings are necessary but not sufficient. If the security is rated, then we know for sure that someone else other than our AMC has seen the paper. But we do not buy into the opinion of the rating agency. Sticking to our processes pertaining to risk management has helped.

What is your view on interest rates?

NBFC across the board have cut down lending and it is affecting the corporate sector, SME, two-wheelers, and cars manufacturers. The system is very tight on liquidity. RBI has cut interest rates and has a neutral liquidity stance but the yields on the AAA-rated PSU papers have gone up after the rate cut in February. 10-year bond yields have not come down. The rate cut is not working out to bring down the interest rates in economy. RBI did some open market operations to infuse liquidity. But that is not sufficient. They need to figure out how to add more liquidity into the system. If RBI infuses more liquidity into the system, then the interest rates in the economy should go down.

Though the interest rates are going down, investors preferred to play credit curve so far. The product positioning is such that investors come to credit risk funds in search of higher returns as compared to other low-risk products. However, the last one and three year time period has seen credit risk funds underperform banking & PSU bond funds. Axis Banking and PSU bond fund has given better one year return (9.62%) compared to credit risk fund (7.67%). How do you explain this?

Yes. It is the case over last one year or so. We have seen yields on AAA-rated portfolios coming down over last one year. This has benefited banking and PSU bond funds in the form of marked to market capital gains. At the same time, the yields on AA-rated securities have gone up. This has resulted in marked to market losses. That ensured that credit risk funds deliver lesser returns than banking and PSU bond funds. However, this is transitory. Credit risk funds structurally still have the potential to offer excess returns over market returns. But for many investors looking for safety in their short term bond investments, banking and PSU bond funds look good.


You have been investing at the short end of the curve in banking and PSU bond fund (average maturity of 2.9 years), whereas Axis Dynamic Bond Fund (average maturity of 6.8 years) invested in a bit longer-dated bonds. Both these categories do not stop you from taking a call on duration, as per the SEBI norms. Then why this difference of stance?

We are sticking to our fund mandate in these cases. Banking and PSU bond fund investors want high quality, stable performance. That also means avoiding long duration as it brings in volatility arising out of a movement in interest rates. So we keep short maturity profile. In our dynamic bond fund we can buy long term government securities. But even in that scheme, our corporate exposures tend to be for a very short duration in nature from the risk management point of view.

You have been maintaining around 11-12% gold in Axis Triple Advantage Fund, which is more or less in line with the scheme benchmark. What is your view on gold?In this scheme, we do not take a view on any of the asset classes. The idea is to stick to the stated asset allocation in stocks, bonds, and gold. The idea is to benefit from this exposure to all three asset classes. To achieve the taxation of an equity fund we have kept a minimum 65% exposure to equity. And rest is split between bond and gold. We do not take a view on gold here.

It is difficult to predict which asset class will perform better in the next one, three or five year time frame. So the better thing to do from the investor’s point of view is to stick to the stated asset allocation and deliver excess returns over market returns in equity and bond portfolio. But in no circumstance, we change the asset allocation.