FundsIndia explains: Credit Opportunity Funds

A couple of weeks ago, we had covered in detail the accrual strategy. To recap, an accrual strategy involves making returns through interest income on bonds held, and not through predicting interest rate cycles. Credit opportunity funds are accrual funds that invest in debt instruments of companies with lower credit quality. These funds are not for all investors, and require proper understanding of the risks involved.

Credit ratings and credit risk

Credit quality is the indicator of the company’s ability to meet interest and principal payments on time. A company with high credit quality will have a high degree of safety in paying the interest due and principal repayment. When a company has low credit quality, the chances of it missing interest and principal payment are higher.

A company’s credit quality is measured by its credit rating, given by rating agencies such as India Ratings & Research, Crisil, Care, and Brickwork. Credit rating depends on the company’s financials, its management and business strategies, the industry it is operating in, the reasons behind raising debt, and so on. Once given, ratings are revisited by the rating agencies from time to time. A credit rating can improve if the company’s financials and prospects improve, or it can worsen if the company falters.

For short-term instruments such as commercial paper, ratings are usually termed – from best to worst – A1 to A4, and then D. In between each grade, there are sub-grades, so to speak, by tagging a ‘+’ or a ‘-’ sign. So, an A1+ is a notch higher than A1, which in turn is one step better than A1-, in turn better than A2+ and so on. Long-term ratings start from AAA at the highest grade to D at the lowest. D in both long-term and short-term indicate that the instrument are in default or expected to move into default soon. Up until that point, it is the possibility of the company being unable meet interest and principal payments and not the certainty that it would. In the world of mutual funds, anything above BBB is usually considered investment grade from a retail investor’s perspective.

In an accrual strategy, the risk you are taking on is credit risk – the risk that interest and principal payments may not be met. Where the fund holds high-quality papers, there the credit risk low and vice versa.

Why credit opportunity

Credit opportunity funds make it a strategy to find debt instruments that are not in the top-rung in credit rating. This enables them to generate higher returns, because such risky companies would necessarily have to pay up higher interest in order to raise debt. Funds may also seek companies that could see their credit rating moved up or get better, which affords them capital appreciation as bond prices rise in such cases. Given the high risk, credit opportunity funds try to mitigate it in a few ways.

One, they do not go very far down the grading scale. They restrict themselves to the AA+/- and the A+/- grades, which are also termed as investment grades. Two, they do not go for long-term debt and stick to bonds that mature in a couple of years. This way, funds ensure that they do not lock into risky instruments for years together. It’s also a lot harder to predict a company’s finances over the long term as uncertainties are higher, especially with companies that are already financially weaker. Besides, companies also typically try to service short-term debt as far as possible since such debt is for day-to-day business.

Three, funds try to get some sort of security either by way of attaching their cash flows directly or other back-ups to ensure that in the event that the company finds the going tough, the fund is able to maximise recovery.

What the risks are

Credit risk is high in these funds. There are two possible events, as a result. The first possibility is that a debt instrument held is downgraded – it is moved to a lower credit rating. A move from AA+ to AA is also a downgrade. In this event, the bond’s price will fall to reflect the new rating and as the interest rate on new instruments issued will carry a higher interest rate. If the bond is not listed, the fund has to get the bond revalued by rating agencies. Whichever the method, the fund has to show the new and lower price in its NAV, a practice called mark-to-market. The extent to which prices fall depends on the extent of downgrade.

But remember that the fund still holds the bond, and the new value is simply the market price. It is a paper loss and not an actual loss. A downgrade does not automatically mean that payments will lapse. The bond will thus carry on paying dues and at maturity, the principal. The paper loss, thus, reverses gradually. If the fund thinks that company may not pay up on time, it can sell the bond. In such a case, the loss becomes real. The trouble is also that such low-grade bonds are unlisted and illiquid. The fund may find it hard to exit and may have to do so at a heavy discount in the unlisted market.

The second and more remote possibility is that the company actually defaults on payment. In this event as well, there is a real loss. The fund again may try to exit the bond.

Who can invest

As an investor, this is the risk that you’re taking for the higher payoff. When there is a fall in the NAV due to either of the two cases, you should be able to wait it out. Even where the loss is real, the interest accrual from the other papers in the fund’s portfolio will slowly extinguish the loss and will eventually deliver gains for you. This is why you need to be a high-risk investor and have a horizon of at least 3 years to invest in these funds. If you cannot take such risks, stick to income accrual or dynamic bond funds, for similar timeframes.