Should you opt for Credit Opportunity Funds?

A credit opportunity Fund is a version of a debt fund. Like any debt fund, the Credit Opportunity Fund (COF) also invests in debt instruments. But there are two key differences. Firstly, in the search for returns the COF is willing to invest in lower rated instruments. Generally, most funds stick to AAA and AA rated instruments to keep the risk of their fund low. The COF goes even lower than AA rated instruments to enhance the returns on the fund. Secondly, there is a greater degree of fund manager discretion in a COF. The fund manager actually takes a call on instruments which are good despite a low rating. He also takes a view on low rated instruments which have the potential to be upgraded in the future. So what should be your strategy with respect to COFs?

Why have COFs come into prominence?

Over the last one year, equity funds have not really gone anywhere as the Nifty has been consistently down since March 2015, except for the spurt post March 2016. With bond yields not falling to the extent expected, the normal income funds have also not done too well. Under these circumstances, these COFs have managed to give returns in the range of 8.5-9.5%, which is highly attractive in the current investment scenario. Of course, the fund manager has to take a higher degree of risk as one goes down the rating curve. It is these higher returns on COFs that have caught the fancy of investors of late.

Try to understand why the fund manager is going down the rating curve…

This is normally available in the monthly fact sheet wherein the fund manager lays out the broad strategy and rationale for the fund. In case of a COF, the fund manager discloses the reasons why they have decided to opt for a higher risk strategy. Investors need to ensure that when fund managers go down the rating curve they must not be adding undue risk for a marginally higher return. The decision to go down the rating curve could either be determined by a sectoral turnaround in a particular group of stocks or the fund manager’s expectations of future upgrades in rating.

Understanding sectoral turnarounds as a COF strategy…

Let us take the example of the power sector. The power sector was languishing till the time the new government managed to assure the supply of coal and initiated long ranging power sector reforms. This has contributed to the solvency and profitability of many power companies across the board. A smart fund manager can anticipate such a shift and take positions in power sector bonds. They may be holding lower ratings due to the problems in the sector. That can change when aggressive reforms are taken up. This is where in-depth research and a crystallized fund manager view on the direction of reforms can enable taking positions in such bonds in advance.

COF allows you to lock in higher yields on bonds…

The beauty of a COF is that the fund manager is able to lock in higher yields in a bond before it is upgraded and its yields go down. For a long term bond locking in higher yields makes a lot of sense, especially when the economy is in the midst of a dovish monetary policy. The reverse can also hold true if the fund manager is expecting a downgrade of the bond, in which case they can exit the bond before its downgrade.

But don’t ignore the risks of a COF…

A Credit Opportunity Fund (COF) also has its share of risks involved. Here are a few of them…

  • When you go down the rating curve, you run a default risk where the company in question may default on the repayment of interest and principal. We have seen that happen in case of companies like Amtek Auto, which almost forced J P Morgan Mutual Fund to freeze redemptions.
  • There is also a liquidity risk when you go down the rating curve. While the handful of high rated bonds tend to be very liquid with narrow spreads, the bonds lower down the rating curve tend to be less liquid. Their prices are also more vulnerable and negative news flows can have a deep impact on their bond values.
  • Ensure that the credit risk of lower rated bonds is only a small part of your COF portfolio. Anything above 20% of AUM is a slightly dangerous situation.

As the name suggests, COFs take proactive views on the bond market and go down the rating curve accordingly. Of course returns will be more attractive than traditional bond funds, but the higher risks cannot be ignored.

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