Debt mutual funds: Corporate bond funds find favour with investors

Yields and spreads on lower rated papers (AA and be-low) remain elevated due to lower demand.

Corporate bond funds, which invest at least 80% of the assets under management in AA+ and above rated instruments, have gained popularity with investors. In FY21, this category reported net inflows of Rs 69,305 crore while credit risk funds saw the highest net outflows of Rs 28,923 crore. Investors took advantage of the flexibility offered by the duration strategy, and Reserve Bank of India preferred an accommodative stance to help pursue growth over inflation.

Flight to safety
Dhaval Kapadia, director, Investment Advisory, Morningstar Investment Adviser (India), says investing in corporate bond funds was perceived to be safer than investing in credit risk funds or other funds running similar strategies. “The ‘Flight to Safety’ accelerated with the onset of the pandemic resulting in nationwide lockdowns and raising concerns around its economic impact, particularly on companies with lower credit ratings which could potentially increase downgrades and defaults,” he says.

In fact, after Franklin Templeton announced winding up of six debt schemes investing in lower credit rated papers in April last year, investors redeemed from credit risk funds and other funds investing in lower credit rated instruments. It appears that some of this money and other fresh debt investments found its way into categories such as corporate bond funds and banking & PSU debt funds.

Harshad Chetanwala, co-founder, MyWealthGrowth, says investors have been more careful in the last one year investing in debt funds. “Corporate bond funds along with banking & PSU debt funds have been top performers within debt funds in the last one year and investors have preferred short and medium maturity duration funds as the interest rates remained low,” he says.

What should investors do now?
Corporate bond funds can be ideal for those investors having a longer-term investment horizon. Investors must look at the actual percentage of the portfolio in AA+ and above rated bonds, particularly if they are concerned about safety and how well it is diversified in terms of instruments and issuers. Investors must also look at the expense ratio as higher expenses will reduce returns. It is particularly important in a scenario where interest rates / yields are low.

As a result of the flight to safety and significant inflows into corporate bond funds, banking & PSU debt funds and other categories holding primarily high quality papers, the demand for such instruments increased as compared with the supply. In turn, this has resulted in a fall in yields of AA+ and above rated instruments, particularly in the one to three-year maturity segment.

Alongside, spreads (or additional yields) for such instruments over government securities also reduced. These are trading below their long-term averages, making them relatively less attractive from a risk-reward perspective as compared with 12-15 months ago.

On the other hand, yields and spreads on lower rated papers (AA and be-low) remain elevated due to lower demand.
Kapadia says yields and spreads on medium to long duration (five years and above) government securities and corporate bonds are looking attractive.

“Accordingly, investors with a three to five-year horizon can consider debt allocation to a mix of corporate bond funds / banking & PSU debt funds, medium to long duration funds and a small portion in moderate credit risk funds with diversified portfolios backed by a strong investment process,” says Kapadia.

Chetanwala says investors can continue to consider corporate bond funds in their portfolio as a part of their debt allocation. “However, they should look at the portfolio of these funds from a credit risk and duration risk perspective. Better the quality of companies in the portfolios, lesser the credit or default risk. As far as duration risk goes, we have to keep in mind that longer the duration, higher the risk,” he says.

Flight to safety
Investors with a three to five-year horizon can consider a mix of corporate bond funds / banking & PSU debt funds, medium to long duration funds and a small portion in moderate credit risk funds
They should look at the portfolio of these funds from a credit risk and duration risk perspective. Better the quality of companies in the portfolios, lesser the credit or default risk
In FY21, corporate bond funds saw net inflows of `69,305 crore