Is it right time to take exposure to credit opportunities funds

Inflation measured by CPI has hit a 17-month high in the month of December 2017. It rose to 5.21 per cent on yearly basis. This rise in retail inflation further quashed any hope of rate cut by RBI anytime soon. This has resulted in a rise of long-term bond yields, which is currently trading at north of 7.5 per cent. Under these circumstances, when interest rates are not going to come down, and bond yields are hardening, it becomes difficult for a debt fund to generate alpha. Nevertheless, credit opportunities fund (COF) are a type of debt fund that has created good returns even in rising bond yield environment. In the last one year ending January 18, 2018, these funds have generated returns of 7.16% on an aggregate basis, which is highest by any type of debt funds.

Most of the debt funds invest in the instruments that are rated as AAA by various credit rating agencies. COFs on the other hand even take exposure to debt instruments that have a credit rating of below AAA and AA. These instruments carry higher interest rate than AAA-rated instruments. Hence these funds generate returns from interest accrual. They also get benefit from an upgrade in the credit rating of underlying securities, which helps in the price appreciation of these securities. Hence, COF is able to generate better returns due to higher interest earned by these instruments as well as price appreciation. In the current scenario, when Central Bank and government both are trying to address the problem of higher debt from both firm’s as well as bank’s perspective, COF can be viewed as a window of opportunity.

Despite all its benefits, COF is recommended only for investors who are willing to take higher risk. We have seen in past that default by a single company can compress net asset value (NAV) of funds to a large extent and wipe out any gain. Moreover, before committing to any fund investors need to thoroughly check the portfolio of the fund and the credit rating assigned to different instruments. Majority of the securities held by the funds should be of the highest quality, that is, AAA-rated and you should not allocate more than 20 per cent of your debt fund exposure to COFs.