Credit Opportunities Funds & How They Work

If you are an investor of debt mutual funds, then you must be aware of credit risk. Debt fund that utilises credit opportunities is called a credit opportunity fund. In fact, it is a type of accrual fund. In this article, we will have everything you should know about credit opportunities funds: funds.

What are Credit Opportunities Funds?

Credit opportunities funds take credit risk for the sake of generating higher yields. For this, they adopt the accrual strategy to provide a better return. Accrual strategy is nothing but buying a company with lower credit ratings at the moment, hoping that the ratings go up. Here, the asset manager adds a lower-rated paper in the hopes of generating higher returns in future.

They often consider any debt fund that is rated below AA a bit on the riskier side. Of course, you should never treat ratings as the last word in fund assessment. Sometimes fund managers also choose a lower-rated paper and anticipate a boost in rating, which will increase its price. But, it also comes with added risks of default. Franklin India Short Term Income Plan, Religare Invesco Credit Opp Fund and DSP BlackRock Opportunities Fund are some of the big names in this arena.  

Who should Invest in Credit Opportunities Fund?

Even though it is a debt fund, credit opportunity funds come with a fair amount of risks. For instance, sometimes the lower-rated papers too have known to be downgraded against expectations. Investors should remember that rise and fall are a frequent feature of these funds – so this is not for the faint-hearted.

Investors who seek a steady income and wants to keep the risk factor minimal should stay away from credit opportunities funds. Also, people belonging to the highest tax slab looking to save on taxes can opt for this. They need to pay Long-Term Capital Gains tax of only 20% rather than 30%.  

Features & Benefits of Credit Opportunity Funds

a) Tax-Efficiency Dividends were previously exempt from taxation in the hands of investors. They are now taxable as per the investors’ income tax slab. Long-term capital gains (gains after three years of holding) are taxable at the rate of 20%. Short-term capital gains are added to the investors’ overall income and are taxed as per their income tax slab.

b) Liquidity Credit opportunity funds have more risks in terms of liquidity. For instance, corporate bonds with a low rating are low on liquidity. It will be tough for the fund manager to exit if lower-rated bond defaults or downgrades.

c) Role of Fund Manager It all depends on the choice of the company by the fund manager. Ideally, credit rating should not be the only criteria fund managers should look for. The scope of the company and its growth potential should also be significant deciding factors. If the firm has more chances of growth, then it will become a rewarding choice of the fund manager.

How do Credit Opportunities Funds work?

Credit opportunities funds make returns either by accruing the coupon payments arising from the securities held by it or by finding benefit from compression in yield spreads. The funds take on credit risk by investing in lower-rated securities, that can be upgraded in the future.

The Interest risk of credit opportunities funds is limited. Also, the average credit quality profile of these funds is quite commendable while keeping the weighted average portfolio default probability very low. Since credit opportunities funds are popular for giving 2%-3% extra returns as compared to risk-free investments, their risk-return trade-offs can be quite high.

Things to keep in mind when Investing in COFs

a. Unless you are market-savvy, do not take any credit-related decision yourself, particularly in higher quantities. Make these calls via diversified mutual funds

b. If you are investing in this type of accrual fund, then it would be best to choose larger-sized funds. This is because their more enormous corpus gives them better scope to diversify and spread the risks

c. Choosing a fund with a lesser expense ratio can be a good idea, especially for first-time investors

d. Always go for a fund with a reputed and experienced fund manager

e. Ensure that the fund’s portfolio is not overly concentrated in any specific group’s securities f. Ideally, keeping your credit opportunity investments in the range of 10%-25% of your fixed-income portfolio is advisable There is a general perception of the lack of opportunities in the debt fund sector.

However, credit funds may not be a wise move always. Your best bet is to start with less aggressive funds that don’t go for very low-rated companies. If you think you can handle more risks, equity funds too can serve your purpose. ClearTax Invest has handpicked best-performing funds from the top AMCs in the country. Start investing.