Credit opportunity funds take higher risks

Allocate only 20-30% of the portfolio to this category, which invests in lower-rated paper to deliver higher returns

Among all debt funds, credit opportunity funds stand out at present. They have outperformed all other fund categories in the past five years. Oneyear average returns of these funds are at 7.5 per cent, three-year at 9 per cent and five-year at 9.4 per cent. The performance looks all the more attractive at present when yields on bonds are volatile, affecting returns from other debt funds.

As these funds have been delivering, their assets under management (AUM) have also been growing steadily. In the past two years, the AUM of credit opportunities funds has grown 53 per cent annually. By February 2016-end, their corpus was ~482 billion and it grew to ~827 billion a year later, according to data from Value Research. At present, their AUM stands at ~1,133 billion.

But before you rush to invest in these funds, understand the risk they carry and whether you have the appetite for it. In an investment product, higher returns come from taking higher risks. In the case of credit opportunity funds, the risk lies in the companies they invest in. They invest in bonds that have higher yields, but the credit quality is lower (rated AA or A). If a company has a lower credit rating, it offers higher interest rates to its investors.

While credit opportunity funds can be a part of the retail investor’s portfolio, investment managers and analysts suggest that the investor needs to first to understand the credit risk. “Traditionally, investors have not looked at the underlying portfolio when assessing a fund, though it’s important to understand the credit break-up of the portfolio. The returns have come obviously because they have taken a higher credit risk,” says Kaustubh Belapurkar, directormanager research, Morningstar Investment Adviser 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 both conservative and is not affected by volatility in interest rates or credit downgrades. It’s best to keep the bulk of the investment in shorterduration funds (70-80 per cent) unless the individual is investing in debt as part of asset allocation for the long term. Long-term investors can look at dynamic bond funds, where fund managers change the portfolio depending on the market situation. Allocate a small portion of the investment (20-30 per cent) to credit opportunity funds, which would help to earn a higher return by taking extra risk.

Investors may be better off investing in credit opportunity funds belonging to larger fund houses. Bigger fund houses can absorb the hit in case of default so that the NAV (net asset value) of their fund does not get affected. Larger-sized funds also tend to be well-diversified.

Investment advisors also say that investors should opt for a fund house that has an established team, which can carry out primary research into the companies before investing in them and understanding the possibility of default risk. Avoid funds that rely on ratings alone. Also, check the fund manager's track record in managing this kind of a strategy.

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.