Sliding down the credit curve can be risky

However, those with a high risk appetite and 3-year horizon can invest about 30% in funds taking a credit call

Yields of 10-year government papers fell about 100 basis points (bps) in calendar year 2014. This year, though, the yields have more or less remained flat, despite rate cuts totalling 75 bps. And, with interest rates likely to remain on hold in the near future, debt funds are looking beyond AAA-rated papers to get a higher yield. These include credit opportunity and corporate bond opportunity funds, as well as some income funds.

What's more, the decline in spread between repo and rates of certificates of deposit (CDs) or commercial papers to 30-40 bps from 50-60 bps a month before has also prompted fund houses to go down the credit curve, says Dwijendra Srivastava, chief investment officer, debt, Sundaram MF.

As of June 30, the percentage of debt investment in AA- and AA papers had risen by 2.1 per cent and 1.37 per cent, respectively, over the year-ago period.

In the past year, at least half a dozen credit opportunity or bond opportunity funds were launched. At present, there are a dozen such funds in the market, with Franklin India Corporate Bond Opportunities Fund being the largest (asset size of Rs 8,788 crore). On average, these have given 10-11 per cent returns in the past year.

Risks

Credit or bond opportunity funds take a deliberate credit risk and seek to gain from mispriced opportunities or gain from higher accrual in corporate bonds that do not enjoy high credit rating.

"Corporate bond or credit opportunity funds are for high-risk investors who understand credit risk. They are the equivalent of holding a sector fund in an equity portfolio," says Vidya Bala, head of MF research at Fundsindia.com. According to Manoj Nagpal, chief executive at Outlook Asia Capital, while the capital might not be at risk as the fund houses could absorb losses in the event of a default, the returns are likely to get impacted: "These funds are not like junk bonds which give significantly higher returns. Considering that they seek to generate 1-1.5 per cent higher returns than normal debt funds, the commensurate risk is higher."

MFs don't go below the long-term A-rated paper but they can technically go up to BBB, which is considered investment grade, say experts. Going below this requires permission of the fund's trustees. "Indian markets are not mature and going below AAA and AA papers is not advisable. Investors should be aware of the risks before investing," cautions Srivastava.

Strategy

Lower-rated papers offer higher interest rates and the possibility of mark-to-market gains if the papers are re-rated.

With the economy expected to improve over the next few years, experts feel this could be a good time to take exposure to these funds. "Data from credit rating agencies suggests the ratio of upgrades to downgrades has been increasing in the past few months," says Bala.

"Invest with a three-year horizon as credit quality does not change over one to three months," says Feroze Azeez, executive director and head of investment products at Anand Rathi Private Wealth Management.

"If the portfolio has a 70:30 split in favour of below AAA-rated papers, investors can get 70-80 bps higher yield than what a CD of the same tenure offers," says Srivastava. Despite the higher returns, Bala believes investors should not invest more than 10 per cent of their overall debt portfolio in these funds.

Experts advise sticking to large fund houses as these might be better placed to take a hit on their balance sheet and make good the losses in the event of a default.

Look at the lumpiness of the investments. If two fund houses have 40 per cent of their portfolio in below AAA-rated papers, invest in one whose portfolio is spread across 20-30 papers rather than one invested in 10 papers. "You can put 30-40 per cent of your debt corpus in these funds as long as it's a large fund house, the scheme is invested in 25 papers at least and the scheme size is not very large," says Azeez.

These funds are less volatile than duration schemes: Santosh Kamath

Interview with MD, fixed income, Franklin Templeton Investments

Several credit and bond opportunity funds have been launched in the past few months. Why the rush?

It was quite common for Indian fund houses to go below the credit curve before the global financial crisis hit home in 2008. After the crisis, fund houses took a step back and restricted their credit play. With the economy on the mend, funds have again become comfortable going down the credit curve.

What are the risks in doing so?

It is not easy to identify risks only by looking at their portfolio. Ratings might not help, as they always move with a lag. Investors should take the help of experts. Once you identify one or two good funds, you can invest a large chunk of money. Depending on your risk appetite, this could be as high as 50 or even 70 per cent of the overall debt portfolio. The good thing is that these funds are not as volatile as duration or government bond funds.

How do you mitigate risks associated with investing in papers rated below AAA?

We try to understand the company over a period of time, meet the management and promoters, as well as credit agencies and equity analysts tracking the company. The research is more hands-on.