Credit risk funds, and the spiral

What the mandate requires

A credit risk fund is required to hold a substantial share of its portfolio in paper rated below the highest grade. That is the category definition, not a choice the manager makes.

Which is worth stating plainly, because the name is sometimes read as a warning label on an otherwise ordinary fund. It is not — it is a description of the strategy. The fund is designed to take credit risk, and the extra yield is what it is paid for doing so.

The proposition is coherent: some lower-rated borrowers repay perfectly well, ratings are imperfect, and a manager who assesses credit better than the ratings implies can earn a premium without suffering the losses. That is a real activity and some managers do it.

The losses do not look like the gains

Here is the asymmetry that defines the category.

The extra yield arrives steadily and in small increments — a slightly higher return every month, accumulating quietly, and looking increasingly like evidence that the strategy works.

The losses arrive suddenly and in large ones. A downgrade or default is marked down at once, and unlike a duration loss it does not reverse when conditions improve. The money is gone.

So the return series of a credit risk fund tends to look excellent for long stretches and then not. A long run of good performance in this category is not evidence that the risk is absent — it is what being paid a risk premium looks like while nothing has gone wrong.

That shape also defeats the usual comparison. Ranking credit funds on three-year returns during a benign credit period ranks them by how much risk they took, and presents it as skill.

The redemption spiral

The mechanism that turns a single default into something much larger, and it is specific to the open-ended fund structure.

1. A holding is downgraded or defaults. It is written down and the NAV falls.
2. Investors redeem, reasonably, having seen the fall.
3. The fund must raise cash. It sells what it can — and in a stressed market, the liquid, higher-quality paper is what sells at a fair price.
4. The remaining portfolio is now worse. The good paper has gone and the illiquid, lower-rated paper is a larger share of what is left.
5. Which prompts more redemptions, and the cycle repeats.

Investors who stay are left holding a portfolio of steadily worse quality, and each round of redemptions makes the position of the remaining holders worse. This is not a theoretical risk — it is the mechanism behind the Indian debt fund events that made this category notorious.

It also explains why the category can seize up: when the illiquid paper cannot be sold at any reasonable price, a fund may be unable to meet redemptions in the normal way at all.

Side pockets

The regulatory response to exactly that problem.

A segregated portfolio — a side pocket — separates a distressed holding from the rest of the fund. Investors on the day of segregation receive units in both: the main portfolio, which continues normally, and the segregated one, which pays out whatever is eventually recovered.

What it fixes is the unfairness of the timing. Without it, an investor who redeemed quickly got out at a NAV that had not yet fully reflected the problem, while those who stayed absorbed it — so side pocketing stops the exit stampede from transferring losses to the patient.

What it does not fix is the loss itself. The distressed holding is still distressed, and the recovery may be partial or nil, arriving years later. A side pocket allocates the loss fairly rather than preventing it.

What to look at before buying one

1. The rating distribution, not the average rating. An average conceals a barbell of very safe and very risky holdings.
2. Concentration. The largest few exposures as a share of the portfolio. A single holding at a meaningful weight is where a bad outcome becomes a serious one.
3. Group exposure. Several holdings from related entities are one risk wearing different names, and this has been the specific failure in past events.
4. Fund size and flows. A shrinking fund is already in step two of the spiral above.
5. Liquidity of the holdings. How much of the portfolio could actually be sold quickly at a fair price.
6. The manager's record through a credit event, not through a benign period. Only the first tells you anything.

All of it is in the monthly portfolio disclosure, which is one of the few fund documents that is not marketing.

Is the premium worth taking?

An honest framing rather than a recommendation.

The extra yield over a comparable-duration fund holding higher-rated paper is the compensation. The question is whether that spread is adequate for the probability and severity of loss — which is a credit judgement, and it is the manager's job rather than yours.

Two considerations that argue for caution in an ordinary household portfolio. First, the debt allocation usually exists to be the stable part. Taking credit risk inside it means the stable part can fall suddenly, which defeats the purpose of holding it — if you want higher expected return with the possibility of loss, equity is a more transparent way to buy that.

Second, the loss is not correlated with anything convenient. Credit events cluster with economic stress, which is when you are most likely to need the money and least likely to have other resources.

None of that makes the category illegitimate. It makes it a considered allocation rather than a way to get a slightly better return on the safe part of a portfolio.

Reading the history honestly

Returns during a benign period tell you nothing about this category. What matters is behaviour during stress.

FNOTrader's Mutual Funds app carries the full AMFI NAV history — around 34 million NAV rows — so a scheme's maximum drawdown and how long recovery took are inspectable directly. In a debt fund, a visible single-day fall in the history is the most informative thing you can find — it tells you a risk materialised, and how the fund handled it.

FNOTrader is not a SEBI-registered investment adviser and does not recommend schemes.

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