Higher returns in credit funds come with higher risks

Investing in such funds requires more research from the investor. Always look at the quality of the portfolio before investing

Credit opportunity funds have given investors an average return of 9.39 per cent over the past year (source: Value Research), which makes them the best-performing debt fund category over this time horizon currently. This is a very attractive rate of return in the current falling interest-rate scenario. But before you rush to invest in these funds, understand the risks they carry and whether you have the appetite for them.

Returns from credit opportunity funds have been high because they invest in bonds having higher yields but lower credit quality (and hence higher risk). Moreover, inflows into credit opportunity funds have been very strong in the recent past. Investment by these funds into lower-rated papers have caused a compression in their yields. The fall in a bond's yield is accompanied by a rise in its price. 

While credit opportunity funds can be a part of the retail investor’s portfolio, they need to be aware of the risks. Says Suyash Choudhary, head-fixed income, IDFC Mutual Fund: “Credit is still a nascent market in India. Both liquidity and price discovery are not as efficient, as, say, in the sovereign debt market. Also, there are virtually no tools through which fund managers can hedge this risk.” He suggests retail investors should opt for conservatively run credit opportunity funds. 
 

Investors should examine the level of risk in a credit opportunity fund before opting for it. "There will be funds that are invested mostly in double-A and A kind of papers. There will be other more aggressive ones that hold most of their portfolio in A-plus, A, and A-minus sort of papers. Opt for a fund whose level of risk you are comfortable with," says Kaustubh Belapurkar, director-manager research, Morningstar Investment Advisor India.

To deal with the higher risk in these funds, investors also need to be conservative in their allocation to them. "Most retail investors in debt funds are recent converts from the fixed-deposit space. They should build a core portfolio that is conservative both on duration and credit. This portion should comprise the bulk of their portfolio. In the balance, which may be referred to as the value-add portion, they may try to earn higher returns by taking some duration and some credit risk," says Choudhary. Depending on the investor's risk appetite, the core portfolio should comprise 70-80 per cent of his debt fund holdings, while the value-add portion should be 20-30 per cent. A conservatively run credit opportunity fund should be part of the latter portfolio. 

Investors may be better off investing in credit opportunity funds belonging to larger fund houses. "Bigger fund houses have the ability to absorb the hit in case of a default, so that the NAV (net asset value) of their fund does not get affected. Larger-sized funds also tend to be well diversified," says Deepesh Raghaw, founder, PersonalFinancePlan.in, a Sebi-registered investment advisor. Belapurkar advises going with a fund house that has an established team which can carry out primary research into the companies their fund invests in to be able to understand the possibility of default risk, instead of relying on ratings alone. He also suggests checking the fund manager's track record in managing this kind of a strategy. 

Investors should also avoid choosing a credit opportunity fund based on higher yield to maturity alone. Finally, do pay heed to the exit load of these funds, which could be applicable for two-three years. "If you need to exit after one year, you may end up paying a one per cent exit load, which will eat into your returns," says Belapurkar.