Downgrades hit corporate bonds credibility hard

The recent downgrades in the corporate bonds have not only lost the money for the investors in these bonds but also the confidence in this kind of investments.

The ILFS saga created ripples and led to the contagion in the non-banking financial institutions (NBFC) triggering more defaults.

The funds exposed to these bonds and/or instruments have to make temporary and, in a few cases, permanent losses reducing the NAV of these funds.

While there are many categories of debt funds, its credit risk funds that predominantly invests in at least 65 per cent in AA rated credit instruments.

The idea is to generate relatively higher return by taking instruments of lower rating. The interest rate fluctuations could create arbitrage and also possible capital gains.

The portfolio of credit risk funds is predominantly with instruments of those corporates or companies which offer high interest rates on the securities they issue due to their lower ratings.

So, the funds earn returns through the higher interest associated with these instruments and also with the capital gains when the ratings of these paper improve.

This is where the risk is borne by the investors, whether the rating improves or not.

The biggest risks of these funds are the liquidity and default risks. When the going is tough for the issuer companies, the liquidity for these bonds turn scarce.

This could lead to further strife if capital is not infused at the right time lowering the issuers' paper to be downgraded setting off a vicious cycle.

At these circumstances, it would be very difficult to exit these holdings and so liquidity risk is high in these funds.

If the situation worsens then it could trigger the corporate issuer to a default. Even a missed interest or a delay of interest payment could effectively put the issuer at risk as a defaulter due to the prevailing rules.

This is where the role of rating agencies come to fore. These are independent institutions which check the health of the borrowing institutions or corporates at regular interval and assign a rating that represents the financial condition.

A stable or investment grade rating allows the borrower to raise capital from the market. The rate (interest) at which a corporate thus squarely depends upon the credit worthiness characterized by the rating.

The better the rating, higher the bargaining power of the borrower and thus would enjoy a lower interest commitment.

Also, some types of investors like trusts, provident funds, endowments, etc. have restrictions on the type of instruments they could invest in.

Most of these institutional investors through their obligations invest in higher secured instruments (AA and above) that helps them to have secure lending even at a relatively lower return.

In order to achieve a better risk to reward, they would employ a bit of lower rating instruments which could be of minority holding in their portfolios.

Credit risk funds come into play in these situations. Hence, these funds are not suited for not suited for investors of all hues. Investors with a high-risk appetite in fixed-income space could look for credit risk funds.

In these types of funds, size does matter as a larger fund could have diversified assets and in case of any liquidity or default risk, the impact could be limited when compared to smaller sized funds.

Investors should also be wary of the concentration risk with instruments of the same corporate and their affiliates in these funds. This could aggravate the risks and could hamper the performance in difficult situations.

Dividends from these funds are tax free at the hands of the investors though a dividend distribution tax of 28.84 per cent is paid at the distributor level.

The returns from these funds are treated as capital gains with gains of three years and above are treated as long-term while the gains from the units below three years are termed as short term.

The short-term gains are treated as per their tax slabs while that of the long term are taxed at 20 per cent with indexation or 10 per cent without.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)