Sunil, a 32-year-old software engineer, feels disheartened when he looks at his investment sheet. He sees the list of fixed deposits and some debt funds that he has invested in and the income he has earned from his investments so far. He feels dissatisfied when he computes his investment returns…he knows he should earn more than the inflation rate, but the returns are just about the same as the inflation rate. He is comfortable with debt investments and wonders if he can find a way to improve his earnings from these investments. He decides to speak to a financial advisor. The financial advisor tells him to consider credit opportunities funds. This is what he learns about these funds:
About credit opportunities funds:
A credit opportunities fund is essentially a debt fund which invests in lower rated (riskier) debt securities – AA and below – than a regular income fund, which is AAA/AA+ oriented. Lower rated debt securities offer higher returns than highly rated debt paper to compensate the investor for taking higher risk. However, fund managers limit risks in these funds by undertaking a holistic and in-depth assessment of the borrower’s financial health and business outlook. The combination of higher returns with close control of risks makes such funds popular among investors.
Advantages of credit opportunities funds:
In comparison to fixed deposits, credit opportunities funds are more advantageous since you receive tax-free dividends from these funds as opposed to interest from fixed deposits, which is taxable.
Credit opportunities funds score better than other debt funds in terms of providing higher potential returns while closely monitoring risks.
Disadvantages of credit opportunities funds:
Similar to any debt fund, credit opportunities funds carry three types of risks:
Credit risk: While technically this fund is riskier than a debt fund that invests only in highly rated (AAA) debt securities, you must not take the credit rating as the sole reason for investing/not investing in a fund. The fund manager and his or her team undertakes a due diligence examination and invests in the debt security only after being convinced that it is a suitable investment. Sometimes, these securities are due for an upgrade in rating and the fund manager invests before the upgrade to benefit from a higher valuation as a result of the upgrade. However, in some situations, a debt security may be further downgraded; hence, credit opportunities funds are suitable for those investors who are able to stomach this risk.
Liquidity risk: These funds carry liquidity risk; that is, the fund manager may not find a buyer for the debt securities invested in.
Interest rate risk: When interest rates rise or fall, the value of existing debt securities falls or rises, respectively. This happens as similar debt securities (in terms of credit risk and tenure) are now available to investors at prevailing interest rates. Consequently, existing debt securities need to be re-priced to make them comparable to new securities. For example, let’s say a debt security’s market price is Rs 100 and it offers a coupon rate of 7.5%; if interest rates rise to 8.0%, the price of the debt security will reset to about Rs 93.75. So, in effect, this debt security will now offer the same yield or return as the market rate (8% of Rs 93.75 equals 7.50%, which is equivalent to the prevailing interest rate of 7.5%). If your fund has this security in its portfolio, it would take a capital loss due to the fall in market price of the debt security. Debt securities that credit opportunities funds invest in will face a rise/fall in their market prices in case of changes in interest rates; hence, they face this risk too.
If you are willing to take on the risk of investing in low-rated debt securities offering high interest rates to earn higher returns than offered by AAA-rated debt securities, then credit opportunities funds are for you. However, it is ideal to limit your exposure in such funds to about 10% of your debt portfolio.
Selecting the right credit opportunities fund is an important measure to control the level of risk. It’s preferable to select a fund with a high corpus, which facilitates sufficient diversification, and a low expense ratio. It’s also important that the fund be managed by a fund manager with sufficient experience and expertise in this area of debt investment.
Tax implications of credit opportunities funds:
Dividends earned on credit opportunities funds are tax-free in the investor’s hands but the mutual fund pays a dividend distribution tax at the rate of 29.12% (this includes a surcharge of 12% and health and education cess of 4%) before paying out the dividend.
Capital gains earned on credit opportunities funds held for less than three years are considered to be short-term capital gains, which are taxed at the rate applicable to the investor’s total income.
Capital gains earned on credit opportunities funds held for more than three years are considered to be long-term capital gains, which are taxed at 20% after considering indexation. Indexation implies increasing the cost of investment in the credit opportunities fund with respect to inflation. You need to use the cost inflation index table published by the government every year to compute the inflated cost of your investment. This helps reduce the amount of your taxable capital gains.
To conclude, credit opportunities funds offer the option of earning a higher return from your debt securities; however, you should have the inclination to take on a higher level of risk to earn higher potential returns. A sensible way to invest in these funds is to allocate a small percentage of your debt portfolio to them.