The recent spike in yields has dealt a rude shock to debt fund investors - many of whom remain blissfully unaware of the nuances of debt investing. A disturbingly large segment of debt fund investors continues harboring the misguided notion that their investments are free of risk.
With the RBI abandoning its dovish stance in its recent policy meet, the immediate chances of aggressive rate cuts have become bleak. Thus, "duration" based debt funds, or funds that invest in high duration bonds that go up in value when interest rates fall, have lost favor to a degree. Fund Managers are now resorting to "accrual" based strategies, or the practice of accruing interest rather than focusing on capital gains. Credit Opportunities Funds are a type of accrual based debt fund.
It's worth noting that lower rated bonds pay higher coupons and have higher yields, and vice versa. This is the area of the debt market that Credit Opportunities funds focus upon - bonds that are not AAA rated, but which carry higher coupons which (if paid) could result in higher returns for investors.
Additionally, Credit Opportunities Funds stand to benefit if any of the papers held in their portfolios undergo rating upgrades. When rating agencies upgrade papers, they trade up - resulting in capital gains within the fund's portfolio. Credit Opportunities Funds take calculated credit risks - after conducting their due diligence, to capture mispriced opportunities within the bond market.
Credit Opportunities Funds seem to have garnered staunch support from the investing community off late. Their collective AUM has swelled from Rs 30,000 crore to Rs 80,000 crore in the past 10 months.
There's a general sense of optimism in the air when it comes to credit opportunities within the mid-yield space. This might be attributed to the expectation that borrowing costs will come down because of the demonetization-led liquidity build-up within the banking system. IDFC Mutual Fund has recently launched a New Fund Offer in this space too.
The risks associated with Credit Opportunities Funds aren't too difficult to understand - the deliberately undertaken credit risk could backfire if the issuers of the papers default, dragging down portfolio returns in tow. Our economy isn't quite out of the woods yet; in fact, we witnessed a slew of high profile downgrades just last month.
End Note: Investors are advised not to go hook, line and sinker into Credit Opportunities fund based on past performance. Ideally, not more than 25 per cent of your debt portfolio should be allocated to them at this stage. For the remainder of your portfolio, stick to a mix of dynamic bond funds and short term income funds with higher rated portfolios.
