Credit Risk Funds — The Debt Category That Can Fall Suddenly

Every debt scheme lends money by buying bonds and similar instruments. The difference between debt categories is largely who the scheme lends to and for how long, as our page on debt funds sets out.

A credit risk scheme is required to hold a meaningful share of its portfolio below the highest credit ratings. Those borrowers pay more to borrow precisely because lenders judge them more likely to run into difficulty, and that higher payment flows through to the scheme.

So the scheme is not trying to avoid credit risk. It is deliberately taking it, in exchange for being paid more. That is a legitimate strategy and it is the opposite of what most people picture when they hear the word debt.

This is the part that surprises investors, because it does not resemble how equity falls.

In most months a credit risk scheme looks calm. Interest accrues, the value creeps up, and nothing on the statement suggests any danger. Then a borrower is downgraded, or misses a payment, and the value of that holding is marked down sharply in a single day.

Depending on how large that holding was, the scheme NAV can fall by a noticeable amount overnight, after years of looking steady. There is no gradual warning on a statement, which is exactly why it catches people who were reading a calm history as evidence of safety. Our page on risk and volatility explains why a smooth record can hide a real risk.

When a holding runs into serious trouble, a scheme may separate it from the rest of the portfolio into what is called a segregated portfolio, commonly known as a side pocket.

In practice that means your holding is split in two. The healthy portion continues to be valued and traded as normal. The troubled portion is held separately, and you receive something from it only if and when the scheme recovers money from the borrower, which may take a long time and may be less than the original value.

The arrangement exists to treat investors fairly, so that people redeeming immediately do not leave the losses behind for those who stay. It is also a reminder that the troubled part may not come back in full, or at all.

The higher running yield is not a bonus. It is compensation for the chance of the event described above.

Over a period with no defaults in the portfolio, the scheme will look better than a higher-quality debt scheme. Over a period that includes one or two, the extra yield may be wiped out and more. Judging the category on a stretch without incidents is judging it on the half of the trade that pays you.

One more point that catches people. Credit ratings are opinions that get revised, and revisions often come after trouble has already started rather than before. A holding can look comfortably rated on the fact sheet you read and be downgraded weeks later. Reading the rating breakdown is still worth doing; treating it as a guarantee of what happens next is not.

Cost matters here too. The expense ratio is deducted from a yield advantage that is being earned by taking extra risk, and our page on the expense ratio explains why that deduction deserves attention in any debt category.

Unlike most schemes, the risk here is legible if you look, and the fact sheet is where to look.

• The credit rating breakdown, showing how much sits in each grade.
• The largest individual holdings, since concentration in a few borrowers means one problem matters more.
• Any existing segregated portfolio, which tells you something has already gone wrong.
• The average maturity, which adds interest rate movement on top of credit risk.

Our page on the fact sheet covers where each of these sits.

A scheme spreads the exposure across many borrowers, so a single default does limited damage rather than destroying the whole holding. That diversification is the main reason to hold lower-rated debt through a scheme rather than directly.

What a scheme does not do is remove the risk. It shares it among all unit holders. Our page on debt funds versus bonds sets out the fuller comparison, including why a scheme never matures the way an individual bond does.

A narrow group, in our view.

Somebody with a horizon of several years, who understands that the value can fall suddenly and may not fully recover, who holds this as a small part of the stable side of the portfolio rather than all of it, and who has read the portfolio rather than the past return.

It is not for the buffer, not for money needed within a couple of years, and not for anybody who chose debt because they wanted to stop worrying. For those needs, liquid funds or gilt funds address different risks, and a deposit remains a perfectly sensible answer. We are distributors rather than investment advisers and recommend no schemes. If you want to check what your debt holdings actually contain, get in touch.