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What you need to know about Credit Opportunities Funds?
05 Jan 2023

Credit opportunities funds (COFs) have been around in India for quite some time but are yet to pick up in a big way. These funds are much more popular in the Western countries where it is a lot harder to search for alpha in debt funds. A COF is by default a kind of debt fund. The only difference is that the COF does not keep its debt portfolio static for a longer period of time. It looks to tweak its portfolio credit quality by adding firms with lower ratings but with good promise of higher returns. Essentially, a COF compromises a bit of the safety factor for the sake of higher returns. It needs to be remembered that COFs are more risky than normal diversified debt funds but do promise that slight alpha compared to regular debt funds.

Normally most debt funds will try and restrict themselves to AAA rated funds and may, at best, go down to AA rated funds. What a COF does is to hold a larger proportion of AA rated funds as also add funds with credit ratings lower than AA. Hence security selection becomes very critical as we have seen in the case of Amtek Auto, where a downgrade by the rating agency led to a sharp compression in the NAV pulling the AMC almost to the brink of a default. Hence fund managers need to be doubly cautious about the default risk in COFs.


How do fund managers approach the COF?

Basically, there are 2 approaches of COF managers. Firstly, there are managers who simply play the credit quality game. They go down the credit curve purely in search of higher returns. The focus of these fund managers will be on funds that are paying higher yields that are proportionately more than the risk implied. This gives an arbitrage opportunity to the fund manager of a COF. Secondly, there is a more active approach. Here the fund manager actually bets on a rating upgrade by the agency. When the rating of the debt instrument is upgraded, it results in a lower yield requirement and therefore higher bond prices. This leads to price appreciation of the bond and therefore higher NAV of the fund.


The COF opportunity if RBI goes slow on rate cuts..

As of now it appears that the RBI may go slow on rate cuts due to higher inflation and also due to the Fed possibly hiking rates again in December 2017. Normally, diversified debt funds prefer falling interest rates as it results in lowering of yields and makes existing bonds more valuable. This results in bond price appreciation leading the NAV of the fund also higher. However, with RBI unlikely to cut rates too aggressively, debt fund investors would be looking at alternatives to improve their alpha. From that perspective COF could be an option. Currently, there are COFS offered by Franklin Templeton and INVESCO but the AUMs are still too miniscule.


Debt restructuring could be another trigger for COFs..

With the RBI and the government chasing mid-sized companies to address the problem of leverage, it could open a new window opportunity for COFs. Firstly, the clarity on the future of debt servicing by these companies may result in rating agencies upgrading the ratings on these bonds. That will become a basket case for COF managers to bet on as it will reduce the yields and increase the prices of these bonds. Secondly, it is also estimated that the yield spread between the AAA rated bonds and the AA rated bonds could narrow further if the leverage problem is addressed satisfactorily. That will again be a case for upgrading AA rated debt and give a window of opportunity for COFs. While these may be early days, there is a base case in favour of the growth of COFs. Of course, the availability of quality AA rated debt could be the big challenge, although that situation is improving now.


Debt is for security; so do COFs make sense in my portfolio..
The larger chunk of demand for debt funds comes from corporate and institutional treasuries. Retail demand in case of debt funds is relatively smaller. For corporate treasuries the COF offers a good opportunity. What about retail investors looking at debt funds as part of their long term financial plan? From their perspective, the COF may not be too meaningful. Most of the retail investors include debt funds in their portfolio purely for the sake of liquidity and price protection. COF can create a problem on both fronts. Hence its utility for retail investors is limited as it goes against the basic grain of long term financial planning and goal setting.
COF may be a good product extension, but it has limited utility for small and retail investors. For corporate treasuries, the COF may be an interesting option to enhance yields.

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