Credit funds, also known as credit opportunities funds or credit risk funds, are essentially debt mutual fund schemes which invest in securities/bonds with lower credit rating. Simply put, the portfolio of these funds majorly are into such debt instruments which are riskier and the chances of their issuers defaulting on debts can’t be completely ruled out.
Nearly 65-70% of underlying instruments of credit funds are rated AA or below securities. Because of the higher degree of risks attached, these low-rated securities tend to offer higher returns in order to compensate for the risks taken by the investors.
Compared with regular debt funds which invest in high-rated debt papers, returns from credit funds are often on the higher side. However, the risk of default in some of the underlying securities is also higher and thus investors need to exercise caution while choosing and investing in credit funds.
Having said that, fund managers always attempt to reduce and limit the risks by taking investment decisions based on in-depth analysis of the borrower’s (the bond issuer’) financial parameters, its business growth prospects, and evaluating the repayment capabilities of such issuers on the maturity. Timely examination of the securities helps fund managers in balancing the portfolios. Therefore, these funds’ ability to generate relatively higher returns along with a close monitoring of the risk factors make them a suitable choice for investors with higher risk appetite in the debt segment.
Benefits of Credit Funds
When compared with plain vanilla debt investments like fixed deposits, recurring deposits or for that matter regular income funds, credit risk funds score better in terms of return generation. On top of it, the dividends (if any) you earn is tax-free which is not the case with various other debt instruments where earned interest is taxable. Further, in due course of time, if the credit rating of any of the underlying securities of such funds is upgraded, it helps in generating higher returns.
Disadvantages of Credit Funds
As is the case with other debt funds, credit opportunities funds have similar risks attached.
a) Risk of Default: If the financial health of the issuer of the debt papers to mutual funds deteriorates during the course of investment, it calls for its ratings downgrade. In such situations, the net asset value (NAV) or the valuations of the asset under management of the scheme get impacted. The investment manager takes care in doing research and due diligence to ascertain whether the papers are worth investing or not. Despite this, issuers may still default. However, the good part is all investments are not done in a single security and thus chances of default in all the underlying investments are not a probability.
b) Interest Rate: It is worth mentioning that valuations of debt securities are inversely proportionate to the interest rates. If the rates fall, the value of debt securities rise, and vice-versa. Therefore, the interest rate trajectory will impact returns from credit risk funds or for that matter any other debt funds. It is advisable to invest more into debt schemes when interest rates are higher in order to keep investment cost low.
c) Liquidity: Since low rated securities do not find several buyers as they are prone to default, these investments face liquidity crunch tantamount to an investment risk. At times, the fund manager of a credit opportunities fund may not find buyers for the debt securities he is invested in. Especially at a time when investors want to redeem, the ability of the fund manager to sell some of the papers can help honour the redemption request. Thus, credit funds run a liquidity risk.
Preferable Exposure To Credit Risk Funds
With the above mentioned pros and cons of credit opportunities funds, it is clear that such schemes have their fair share of risks but rewards are also on the higher side compared with regular debt funds. Only those investors who want to chase the higher yields on their debt investments and have considerable risk taking ability should invest in credit funds.
It is advisable to invest up to 10% of their debt portfolio in credit funds. If one has an aggressive approach, the allocation may be stretched up to 15%. Above these levels, one will end up taking high leverage and move away from the investment basics of risk-adjusted return. Further, it is advisable to choose credit risk funds which are bigger in size. This will help investors do away with the concentration risks seen in smaller-sized credit risk schemes. For debt investors with low to moderate risk appetite, credit risk funds do not make a suitable choice and thus should be avoided.
(The author is CEO, Bankbazaar.com)