Thursday, 23 June 2016

Credit Opportunities Fund - A Complete Guide

If you have a slightly higher risk appetite and investment horizon of 18 to 24 months you can consider Credit Opportunities Fund

While retail investors showed great interest in equity mutual funds in the last two years, another debt fund known as credit opportunities fund too saw higher participation by investors. In the past 18-24 months retail investors have continued to pour their money into these debt categories as they have given better returns.

Since mid-2014, credit opportunities funds have been the flavor of the season as several fund houses have launched them on the back of huge demand from investors.
In 2014 alone, over 15 credit opportunities schemes were launched. In the last calendar year though, it had slowed down to six scheme launches by various fund houses.


Credit-Opportunities-Fund
Image Source : Advisorkhoj

This article explains the history, advantages and disadvantages of credit opportunities funds and how investors should invest in them


WHAT ARE CREDIT OPPORTUNITIES FUNDS ?


A credit opportunity fund is a type of debt fund in addition to liquid, income and gilt funds. The credit opportunities fund adopts an accrual strategy and takes credit risk for the sake of generating high yield to provide better returns

Many funds like short-term debt funds, which invest part of the overall portfolio in a lower-rated paper to deliver higher returns fall in the ambit of credit opportunities funds. Credit opportunities funds aim to generate higher returns by investing in reasonable credit quality securities with a diversified approach.

Typically, credit opportunities funds invest in low credit-rated funds like less than “AA” rated. Lower the credit rate, higher the return. But on the other hand, the risk of default also increases. This could eventually impact returns on the funds.

Unlike debt funds like income or gilt funds, which generate returns through price appreciation in underlying bonds by timing the interest rate cycle and playing the duration strategy, credit opportunities funds adopts an accrual strategy where returns are generated by high yield instruments.

While income and gilt funds are exposed to interest rate risks, credit opportunities funds face default risks. In a credit fund, liquidity is also a big risk as most securities rated below AA are not traded actively in the market. In the event of large redemptions, it becomes difficult at times to sell such securities at the desired price. It may force credit opportunities fund to exit from more liquid securities to provide for redemptions, enhancing the risk profile of the fund.

It needs to be noted that, in both the downgrades that have happened in the past, investors have lost some returns as NAVs of the schemes have come down. Fund houses were forced to sell their underlying papers as loss, eventually hurting their profits.


WHAT WENT WRONG WITH CREDIT OPPORTUNITIES FUNDS?


Credit opportunities funds were delivering stronger returns and had, therefore, caught investors’ attention. In the last three years, credit opportunities funds on an average have given returns of around 10%, higher than income and gilt funds that gave 8% and 9% returns respectively, in the same time frame. Even in the last one year it managed to give 9% returns, which is still higher than other debt instruments.

Here investors thought that these kinds of returns were possible if one took interest rate risks. However, there are a few funds in the income accrual category that deliver high returns for taking on a different kind of risk, known as ‘credit risk’ through investments in corporate bonds.
Fund managers managing credit opportunities funds are willing to bet on improving fundamentals by taking exposures in debt instruments of such companies as they offer attractive coupon rates. Such funds aim to generate higher income on a regular basis, without having to worry too much about interest rate movements.

Global capital markets have witnessed extreme volatility in the last one year with a sharp fall in commodity prices, particularly crude oil, sharp depreciation of merging market currencies and weak global equity markets.

All these have led to a sharp change in fundamentals of many companies, particularly those that are related to commodity sectors like metals, oil and gas, which have been worst hit.The case is same with other domestic companies and sectors. Credit ratings of a number of manufacturing companies from the steel, oil & gas, textiles, etc, sectors have been downgraded due to the drop in margins. With global commodity prices trading near all-time lows with no signs of reversal, the stress in related sectors may continue in the near term.But in the last few months, credit quality of portfolios of debt mutual funds have come under the scanner following credit rating downgrades of a few companies by rating agencies.

Having said that, many industry players believe that there is no major structural change in the overall credit environment; there is a need to exercise caution while investing in such financial products


WHAT SHOULD YOU DO WHILE INVESTING IN CREDIT OPPORTUNITIES FUNDS ?

Any investment vehicle - be it equity or debt - needs to invest by matching risk profile with the risk return profile of investors, especially now when there is weakness in the global and domestic economic environment.Investors should remember higher the exposure of a fund to below AAA rated debt papers, higher would be the return. But at the same time there is higher credit risk in case of a rating downgrade or an eventual default.

Therefore, conservative investors should avoid investing in funds having higher exposure to A or AA-rated papers. On the other hand aggressive investors may select funds with higher below AAA-rated papers depending upon their risk appetite.
Corporate bond funds are suitable only if investors wish to hold it for not less than three years (please note that most funds have a steep exit load for redemptions before this period), and if they can take higher risks than they would take for other debt funds. They should also be prepared for short periods of negative returns.

Investors should match their time horizon with the fund’s modified duration to ensure that their time frame matches with that of the fund. Also, watch out for high exit loads. Ultimately, investors must invest in them only if they appreciate fully the risks these funds hold. The three-year holding period, besides lowering risk,
will also ensure that investors enjoy the capital gain indexation benefit.

The main plan to invest in credit opportunities fund is to cushion the risk of what investors have already in equity investment by diversifying efficiently. So, investors who are not willing to take risks should invest in other debt products, while investors who understand the risks and are willing to have investment horizon of three to five years should allocate some portion of the money to credit opportunities funds.



Best 3 Credit Opportunities Funds
Fund1 Month Return 3 Month Return 1 Year Return 3 Year Return Expense Ratio Alpha
SBI Corporate Bond Fund 0.72.59.5410.351.66%4.74
DSP BlackRock Income Opportunities Fund0.742.419.79.61.80%3.62
Kotak Income Opportunities Fund - Regular Plan0.761.199.179.031.60%2.92



TO SUMMARIZE

The rate cut by the Reserve Bank of India (RBI) last year and expectations of further rate cut in the current calendar year will help corporate bonds and credit opportunities funds. Assets under management (AUM) of credit opportunities funds has increased significantly over the last four years on the back of record
inflows as low sovereign and high grade bond yields pressed investors to lower-rated securities in search of higher yields.

The cumulative corpus of credit opportunities funds increased significantly from around 12,000 crore in January ’12 to approximately 63,000 crore as on January ’16.
However, investors should not go by names of funds alone. Before investing, investors must look at the holding of corporate bonds, their credit rating, and the average maturity profile of the fund before taking an investment call.

The market outlook and the overall credit environment used to be stable prior to the recent global market turmoil, which led fund managers to take exposure to reasonable level of credit risk. However, with the sharp fall in commodity prices especially crude oil recently, slowdown in major global economies, particularly China and sharp depreciation in emerging market currencies, the overall credit environment has deteriorated.

Many fund managers have started taking aggressive calls and are moving away from below AA-rated papers over fear of default. Even rate cut expectations have forced several fund managers to look at government securities (G-Secs).

In the changed global and domestic environment, there is a need to re-assess the potential credit risk and take a final decision according to the  risk profile of an investor.


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