How IDFC Mutual Fund managed credits risks in debt schemes by putting safety first

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After the Franklin Templeton debt schemes fiasco, credit funds have been lying low. However, the IDFC Credit Risk Fund, which is among the later entrants in the category, stands out for its conservative approach and resilience. A Moneycontrol analysis of 17 credit risk funds shows that this scheme has a higher allocation to government securities and has not gone down the rating curve aggressively. Senior Vice-president of fund management at IDFC Mutual Fund, Arvind Subramanian, says that G-Secs provide adequate liquidity to the portfolio. He has prior experience as a ratings analyst as well. In a conversation with Vatsala Kamat, he talks about the impact of these uncertain times on credit risk portfolios and how investors must look at this segment in the overall allocation to fixed-income assets. Excerpts.

What has been your learning from the debacle in debt funds in the last few years?

Since the launch of our credit risk fund in 2017, we have observed that the credit market is relatively illiquid. And there is a lack of hedging instruments in the credit market. That is why we do not take excessive risk. It helped us in the challenging market conditions last year. We were able to generate sufficient liquidity from our AA-rated securities without needing to sell too much of our AAA-rated securities, thus preserving portfolio liquidity.

The credit risk crisis helped us appreciate the importance of scheme liquidity. The biggest learning for investors is that over-allocation to credit-oriented funds, as part of fixed income asset allocation, must be avoided.

What has IDFC Mutual Fund’s approach been towards the credit risk category?

We were among the later entrants to the credit risk category. At the time of our launch in 2017, our strategy focused on the ‘mid-yield’ segment (largely the AA segment) that had better liquidity and price discovery as compared to ‘High Yield’ securities. We have always been aware of the limitations of relative illiquidity and the lack of hedging instruments, in the Indian credit risk market.

Hasn’t this approach impacted the fund’s returns vis-à-vis those of peers?

There are phases in the market when higher yields influence a scheme’s performance. At such times, schemes that have ventured lower into the rating category tend to outperform. But we will not dilute our risk just to get a better yield. Some periods of relatively lower performance are not worrisome as, over time, the risk-reward pays off.

How should an investor build a debt fund portfolio?

Follow a core-and-satellite approach to picking debt funds. The bulk of the portfolio should be in core fixed-income products, which mimic fixed deposits. So, both interest rate and credit risks are limited. A small allocation can be in satellite products depending on a person’s risk appetite. These satellite products can be dynamic bond funds or credit risk funds.

But can such a portfolio beat bank fixed deposits? How does it help an investor?

A good fixed income portfolio is not just about returns. Fixed income allocation should cushion the portfolio when the overall economic growth is weak. A portfolio with high equity and credit risk exposure (within fixed income) is pro-growth. It will do well when the economy is robust.

But credit risk schemes may not provide a buffer when economic growth falters. Hence, quality-oriented fixed-income products should form a bulk of the fixed-income allocation.

Are investors interested in credit risk funds again?

At the start of the previous financial year, there was a sharp drop in the AUM of credit risk funds across the industry. However, things are slowly starting to stabilize. Inflows in the credit risk category are picking up, albeit at a very modest pace. This is good because the high inflows we saw a few years back meant that excessive risk was being taken by investors and there was perhaps an over-allocation to this category.

From a valuation standpoint, the credit spreads currently on offer are not as attractive. This is because many corporates have de-leveraged sharply over the past year, amidst the first wave of COVID-19 and hence supply of credit papers is limited. Further, the rebound in economic activity after the end of the first lockdown has improved market perception of credit risk, resulting in sharp spread compression.

But the second COVID-19 brings with it, a new round of uncertainties. It’s best to be aware about credit risk and how much reward you get versus the risks you take.

Does this warrant a change in portfolio allocation?

Yes, absolutely. Chasing credit spread assets hereon may not be warranted due to the relative unattractiveness. Given an uncertain environment, the portfolio must include a higher quality basket of debt instruments that are AAA rated. Fund managers of credit risk schemes, specifically, should be mindful of liquidity in the portfolio and also concentration risks.

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