It is a misconception that fixed income literally means fixed returns. Investors have been historically sold fixed income products in such a manner ie. with a promise of fixed returns and capital safety. However, there are myriad types of fixed income products which feature at various points along the risk/return spectrum. It is imperative for investors to understand this because when expectation does not meet reality, there is dissonance and discontent. Investors have faced this perceived breach of trust as recently as September 2018, when the AAA rated bonds of a certain corporate were downgraded to default rating in a matter of weeks. This had a cascading impact on the market. The liquidity conditions were poor and there was a general run on funds, making things even worse. Rating agencies got into action and there have been several more downgrades than upgrades since September 2018.
It is time that investors understand the reality of fixed income products. First things first, there are risks inherent in nearly every type of investment product, be it equity or fixed income. It is important to be able to identify the investment profile and risk profile and select funds accordingly. In fixed income funds the lowest risk is in overnight funds and the highest risk in credit risk funds. Credit risk funds have lower interest rate risk and higher credit risk. Unlike the duration-based funds these funds typically have medium term duration therefore, they are less volatile compared to duration-based funds. Credit risk funds in India, by regulation, are mandated to invest more than 65% of the investable corpus in AA or below rated papers of corporates. As the name suggests, the highest risk is that of default. Consequently, the rewards are also higher.
While investing in such funds, investors need to scrutinise various aspect some of which are listed below:
Evaluate the prevalent microeconomic and macroeconomics conditions
Fund exposure to Housing Finance Companies (HFC) and Non-Banking Finance Companies (NBFC)
Exposure to sectors that are not performing well in the current market
The quality of the investment managers and their past record is also of paramount importance. It is prudent to look at the association of the fund manager with the said fund. It reflects the performance of the fund manager during multiple credit cycles
Fund diversification - a concentrated portfolio may lead to higher losses. Group level exposure would help ascertaining the overall exposure to a particular corporate house.
Credit risk funds have relatively higher risk and higher potential to generate returns. Being aware of the risk/return structure of the investment product can help you make optimal portfolio decisions.