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Tata Capital > Blog > Wealth Services > Understanding the Credit Quality of Debt Funds

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Understanding the Credit Quality of Debt Funds

Understanding the Credit Quality of Debt Funds

Mutual funds are among the most convenient investment options for a number of reasons. They come in a variety of categories like equity funds, debt funds, hybrid funds and even sectoral or thematic funds. This makes them suitable for all kinds of investors, irrespective of what their financial goals may be. Secondly, mutual funds also allow you to invest through the Systematic Investment Plan (SIP) strategy, which can be very handy if you do not have a lump sum amount to invest, but wish to save up systematically anyway.

Among the different types of funds available, debt mutual funds are highly suitable for conservative investors who are looking for guaranteed returns and for those who are not ready for equity exposure yet. Although the potential to generate returns may be higher in equity funds, debt funds help create wealth with little to no risk attached. Some debt mutual funds also provide regular income to the investor.

So, if you wish to include debt mutual funds in your portfolio, you will need to factor in many aspects before you make an investment decision. Factors like the assets under management (AUM), the fund performance, and the expertise of the fund manager are all important. Additionally, you will also need to take a look at the credit quality of the fund.

Additional Read: Advantages of Having Debt Mutual Funds in Your Portfolio

Credit Ratings

What is the credit quality of debt mutual funds?

The credit quality of mutual funds is an indicator that gives you an idea about the credit-worthiness of a bond or a bond portfolio. Simultaneously, it also gives you a fair idea about the default risk associated with a fund. So, if you take a look at the credit rating of a debt fund before you invest in it, you’ll get a better understanding of its credit quality and of how safe it is to invest in that fund.

Here’s a preview of some of the terms used to indicate the credit quality of mutual funds, so you get a better idea of what the credit ratings stand for.

Long-term funds

Credit ratingCredit quality of mutual funds
AAAHighest degree of safety and lowest credit risk
AAVery high degree of safety and very low credit risk
AAdequate degree of safety and low credit risk
BBBModerate degree of safety and moderate credit risk
BBModerate risk of default
BHigh risk of default
CVery high risk of default
DIn default (or likely to be in default soon)

For long term credit rating of debt papers rated AAA through to C, the modifiers “plus” or “minus” may be appended to the rating symbols to indicate their relative position within the rating categories concerned. Thus, the rating of AA+ is one notch higher than AA, while AA- is one notch lower than AA.

Additional Read: How can a long-term investment approach help manage a crisis?

Short-term funds

Credit ratingCredit quality of mutual funds
A1Very strong degree of safety and lowest credit risk
A2Strong degree of safety and low credit risk
A3Moderate degree of safety and higher credit risk than A1 and A2 funds
A4Minimal degree of safety and very high credit risk
DIn default (or likely to be in default soon)

For short-term debt papers rated A1 through A4, there is a modifier – a plus symbol – that’s added to signify that such a fund is of a higher credit quality than a fund in the same tier without the modifier. For instance, the credit quality of mutual funds rated A1+ is considered to be higher than that of A1 funds.

Choosing the top-rated funds based on credit quality

As is evident from the rating table we’ve seen in the previous section, the credit quality of mutual funds are not all the same. Some are safer investments than others. Typically, if you’re looking to invest for the long term, it is a good idea to choose AAA rated funds. And by the same coin, if you wish to invest for the short term, A1+ rated funds are the best options available.

In addition to this, G-Secs are also excellent investment options if you’re looking for zero credit risk debt mutual funds. Also known as gilt funds, they are highly liquid instruments that carry practically no credit risk, since the government of India is the borrower. However, please note that gilt funds are extremely volatile as they carry a high duration risk.

Looking past credit quality: Accounting for company specific risk

It’s important to factor in the credit quality of mutual funds, no doubt about that. However, it’s also important to look past the credit rating and account for company specific risk as well. That is because financial crises like the IL&FS incident or the DHFL issue could occur, making it difficult or impossible for the companies to fulfill the financial obligations associated with their debt instruments. In fact, post the default, the long term papers of IL& FS, the credit rating agency ICRA downgraded the company’s bonds from AA+ to BB. And in DHFL’s case, CRISIL downgraded the short term papers i.e. commercial papers of the company from A4+ to D.

Conclusion

This is why it is important to also look into the financial strength of the companies whose instruments debt funds invest in. That way, you can steer clear of such unexpected losses. It is a good idea to perform a quick fundamental analysis of the companies involved. It also helps if you choose a reputed financial services provider. Tata Capital Wealth, for instance, offers a variety of top-quality debt funds for conservative investors who are looking for safe assets for their portfolio. If that sounds like you, you could always choose from the many debt funds on offer at Tata Capital Wealth to add to your portfolio.

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