Credit risk funds are the type of debt mutual funds that carry higher risk compared to other debt funds, but considering the higher risk, can you anticipate an excellent double-digit return from this type of debt mutual fund in the long run?
Based on Value Research data, we discovered that out of 371 active debt funds, 5 have provided double-digit SIP returns in three and five years, while four have provided double-digit returns in ten years. However, just three credit risk funds have consistently provided double-digit SIP returns across three, five, and ten years.
This indicates that in the long term, these funds outperformed other popular fixed-income investments such as fixed deposits and small savings schemes for investors seeking steady, predictable returns and higher liquidity in the event of an emergency.
But since debt funds are not completely risk-free, investors should not expect similar returns in the future; hence, they should check other factors as well, beyond just past SIP returns, before investing.
Top debt funds with consistent SIP returns in 3, 5 and 10 years
Here are three debt funds that have stood out in terms of consistent SIP performance across all three time horizons.
| Funds | 3-Year SIP Returns In % | 5-Year SIP Returns In % | 10-Year SIP Returns In % |
| DSP Credit Risk Dir | 15.4 | 14.79 | 10.86 |
| ABSL Credit Risk Dir | 13.79 | 12.45 | 10.21 |
| Bank of India Credit Risk Dir | 12.36 | 16.35 | 10.73 |
Source: Value Research as of 31st August
Lump-sum performance
| Fund name | 3-Year Returns In % | 5-Year Returns In % | 10-Year Returns In % | Category Average – 3Y (%) | Category Average – 5Y (%) | Category Average – 10Y (%) |
| DSP Credit Risk Dir | 16.75 | 13.31 | 8.77 | 9.73 | 10.5 | 7.74 |
| ABSL Credit Risk Dir | 13.14 | 10.9 | 9.36 | 9.73 | 10.5 | 7.74 |
| Bank of India Credit Risk Dir | 10.06 | 27.75 | 2.49 | 9.73 | 10.5 | 7.74 |
Source: Value Research as of 31st August
Note: Credit risk funds are debt funds that invest at least 65% of their money in low-rated corporate debt instruments to produce better returns.
Simply put, these funds carry higher credit risk than most other debt funds because the fund manager invests in bonds rated AA or below, which indicate that the issuer is more likely to experience financial difficulties or default.
However, investors should note that this debt fund category has been the top performer over the last 1, 3, 5, and 10 years, with CAGRs of 8.16%, 8.90%, 9.66%, and 6.89%, respectively. According to Value Research, credit risk funds beat 17 debt fund categories over the stated periods.
What has triggered the spike?
The strong three, five and ten year returns in some debt funds, particularly credit risk funds, need to be understood in the context of what happened to their portfolios during the period.
There are 4 to 5 funds which have delivered double-digit returns in the category over the last 5 years. However, looking at the returns in isolation is not the right way.
“For example, in the last 5 years, as per ACE MF, Bank of India Credit Risk Fund delivered 27% CAGR over the last 5 years, but this was due to an extraordinary 150% return it delivered in FY22. If we check its historic returns, the fund had suffered massive write-downs earlier on exposures to DHFL, Essel Group, Coffee Day and other stressed credits, with returns of -29% in FY19 and -72% in FY20,” said Arjun Guha Thakurta, Executive Director at Anand Rathi Wealth.
“The sharp rebound in FY22 was largely driven by write-backs and recoveries from DHFL and Essel Group exposures. The second-best fund, which was DSP Credit Risk Fund, also follows a similar pattern, where FY23 had extraordinary returns,” he further added.
Therefore, when looking at long term debt fund returns, investors need to understand what actually drove the performance rather than simply extrapolating the historical number.
How should investors evaluate best debt funds?
Investors should be careful about taking tactical calls on debt funds based on the interest rate cycle. By the time a rate hike or rate cut becomes obvious, a large part of the expected move is often already reflected in bond prices, making it difficult to consistently capture the entire cycle.
“Longer duration funds can benefit more when rates fall, while shorter duration funds tend to be more resilient when rates rise, but moving between them at the right time is easier in theory than in practice. For most investors, debt should therefore be approached with a strategic horizon rather than as a rate cycle trade,” stated Thakurta.
Yield to maturity (YTM), average maturity and modified duration remain important metrics to understand the risk and return profile, but the objective should be to choose a fund suited to the investment horizon rather than trying to predict the next rate move.
Debt funds: Red flags beyond returns
Past returns alone should never be the reason to select any type of fund. The first check should be the credit quality of the underlying securities, particularly the exposure to lower-rated or concentrated credits.
Maturity and duration also matter, as a fund with higher duration can be more vulnerable to interest rate movements.
Another red flag is an illiquid portfolio, especially where the fund holds bonds of smaller companies that may be difficult to sell during stressed market conditions.
How risky is your debt fund?
It is very important to check Potential Risk Class (PRC), duration and credit exposure factors because they tell an investor how much risk the debt fund is actually taking.
“The PRC classification gives a simple view of the fund’s interest rate and credit risk, while duration tells us how much the NAV could move when interest rates change. Credit exposure shows the quality of the bonds the fund holds and the risk of a default or downgrade,” commented Thakurta.
Before investing, investors should therefore look at the fund’s PRC classification, YTM, duration, average maturity and credit rating mix.
When and why should investors add debt funds in their portfolio?
The primary role of debt funds in a portfolio is to provide stability and liquidity, rather than to chase high returns. The allocation should therefore be driven by the time horizon of the financial goal.
“For example, for a goal that is 5 years away, for instance, a portfolio can have around 20% in debt and 80% in equity, allowing equity to remain the core driver of long term growth. But if the goal is only a year away, investors can have the entire allocation in debt,” stated Thakurta.
According to him, over longer periods, equity remains better placed to deliver consistent wealth creation, while debt plays the important role of protecting and stabilising the portfolio as the goal approaches.
Disclaimer: This article is for informational purposes only and should not be construed as investment, financial, tax, or legal advice. Any illustrations, examples, or return projections used in this article are for explanatory purposes only and do not guarantee actual investment outcomes. The views and opinions expressed by experts quoted in this article are their own and should not be considered investment recommendations. Readers should consult a qualified professional before making any financial decisions.
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