In recent news, Franklin Templeton Mutual Fund, one of India’s largest fund houses, announced the closure of its six credit risk funds. This decision was primarily due to the severe market dislocation and illiquidity instigated by the Covid-19 pandemic. A fund house is a company that manages the pooled capital from investors, investing it in financial securities such as stocks, mutual funds and equities.
Understanding Credit-Risk Funds
Credit-risk funds are classified as debt funds and must have a minimum of 65% of their investments in less than AA-rated, meaning lower-rated, papers. The fundamental aim of debt funds is to generate returns for investors by investing their capital in various avenues, including bonds and other fixed-income securities.
What does Investment Grade mean?
Investment grade pertains to the quality of a company’s credit. Typically, any score that falls below a ‘BBB’ rating is deemed non-investment grade. Interestingly, these funds have the potential to yield an additional 2-3% in returns compared to risk-free higher rated papers.
How do Credit-Risk Funds Generate Returns?
There are two primary ways Credit-risk funds make returns. Firstly, they earn interest income on the securities they hold. Secondly, since they invest in lower-rated securities, they have the potential for capital gains if the security’s rating is upgraded.
Risks Associated with Credit-Risk Funds
It’s important to remember that investing in credit-risk funds comes with its share of risks:
Liquidity Risk
Credit-risk funds inherently carry a higher liquidity risk. If a portfolio’s lower-rated bond defaults or faces further downgrades, the fund manager may find it challenging to exit the holding.
Concentration Risk
Concentration risk is another significant factor to consider. If the fund’s portfolio is heavily concentrated or has high holdings in any single business group, then even a single default by that business group can adversely affect the entire portfolio.
Information Source: IE