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Bond funds that are cousins but not twins

Corporate bond funds and credit opportunities funds are similar but not the same

With over 2,000 mutual fund (MF) schemes on offer, it’s easy to get confused as to how one differs from the other. And when it comes to debt funds, there is perhaps more confusion.

Take the case of corporate bond funds and credit opportunities funds, and try to decide which ones to invest in. Both invest in corporate bonds and both aim to invest in slightly lower rated scrips (one goes further lower than the other), hoping that credit upgrades of underlying scrips would benefit the schemes. So far this year, four fund houses have launched corporate bond funds. Corporate bond funds and credit opportunities funds are close cousins, but not twins. Both are riskier than the plan-vanilla diversified debt schemes, but are they really that different and should we be thinking of investing in them?

What are these?

Typically, a debt scheme invests in scrips that carry a high credit rating. Credit rating is an indication of the underlying company’s health and its ability to repay its debt. The higher the rating, the better are its chances to repay its debt on time.

A credit opportunities fund invests in debt scrips across the credit rating spectrum. Though it could invest a negligible portion in AAA-rated scrips (highest credit rating), it invests substantially in scrips rated below AAA.

“To put it simply, these funds look for an opportunity for a possible credit upgrade; like investing in an A-rated scrip that has the potential to get upgraded to a AA rating", says Vishal Dhawan, a Mumbai-based financial planner. So, these funds invest, mostly, in low-rated scrips.

A corporate bond fund, alternatively, doesn’t necessarily invest in low-rated scrips. Meant for investors who want to invest money for about three-four years, these schemes invest in a mix of corporate bonds that are highly rated as well as those that carry a moderate (if not lower) credit rating. “Corporate bond funds invest in well managed companies where the company’s fundamentals have improved but the credit rating has not. Credit opportunities funds are high-risk, high-return products, corporate bond funds are moderate risk, moderate return products", says Santosh Kamath, managing director, local asset management-fixed income, Franklin Templeton Investments India.

As the economy turns around, sentiment improves and companies start to do well, debt funds have turned their attention to investing in the debt scrips of these companies. Better profitability and stronger balance sheets leads to improvement in credit ratings and scrip prices. Hence, quite a few of the fund houses have either re-branded their existing funds or launched new ones to tap this space.

It’s a very thin line

Meanwhile the confusion continues. Franklin India Corporate Bond Opportunities has invested less than 10% in AAA-rated scrips so far this year. In contrast, Principal Debt Opportunities Fund-Corporate Bond Plan has invested 57% in AAA-rated scrips as per its August 2014-end portfolio.

Also, a cursory glance of portfolios of credit opportunities funds and corporate bond funds within the same fund house would show many similar securities. For instance, ICICI Prudential Corporate Bond and ICICI Prudential Regular Savings funds have common names such as Adani Ports and Special Economic Zone Ltd, Dalmia Bharat Sugar and Industries Ltd, Nirma Ltd and so on.

Reliance Corporate Bond and Reliance Regular Savings-Debt funds have common names such as Dewan Housing Finance Corp. Ltd, Aditya Birla Retail Ltd, Bharat Aluminium Co. Ltd and so on. Of course, that’s not to say both portfolios are identical, but there are similarities.

Besides, both categories avoid government securities. And almost all schemes in both these types of funds can invest in scrips that are rated as low as A-.

Accrual or duration strategy

Typically, debt funds aim to make money by navigating either of the two kinds of risks; interest rate risk (also known as duration strategy) and credit risk (also known as accrual strategy).

Duration strategy funds aim to capitalize on interest rate movements; they increase their duration when interest rates fall (interest rates and bond prices move in opposite directions) and vice-versa when interest rates rise.

Accrual strategy funds aim to generate a higher income, on a regular basis, without having to worry too much about interest rate movements. They do this by investing in lower rated scrips because their yields are higher (to compensate for lower credit ratings). Also, if the underlying scrips’ credit ratings improve, their prices—and therefore the debt fund’s net asset value (NAV)—also goes up.

“Typically, a credit opportunities fund, say Reliance Regular Savings Fund-Debt, focuses on accrual. It doesn’t aim to make any reasonable return out of any capital appreciation," says Amit Tripathi, chief investment officer-fixed income investments, Reliance Capital Asset Management Co. Ltd. That is because fund houses would typically want to be exposed to credit risk over a shorter time frame. “And since a corporate bond fund takes a longer term exposure, we analyze the company’s balance sheet and look into its numbers. They have to be sound, despite a slightly lower rating," adds Tripathi.

So typically, a corporate bond fund is focused on duration, along with a little bit of an accrual strategy.

Managing credit risks

Companies that are low-rated carry a default risk. Any such default causes their prices to drop sharply; the NAV also falls. Usually, investments in securities are one-on-one deals; companies that require money approach fund houses either directly or through a money arranger.

The debt fund manager assesses the borrower (company), terms of issue, tenor of the loan and the borrower’s credit rating before deciding which MF scheme can lend (invest) to the borrower.

Sujoy Das, head of fixed income at Religare Invesco tells a tale of a chief financial officer of a company who visited him last year for money. The company’s debt scrip was on offer, but the company was rated low. When Das ran the company’s numbers through Religare Invesco’s in-house filters, it didn’t come out favourably. “The moment I entered the meeting room to meet him, he said to me ‘I need to borrow money for a year’ without even waiting for me to sit down. After a few minutes into our conversation when I almost rejected him, he persisted and said ‘okay, at least lend me for six months’. I sensed desperation; it was a turn-off. Eventually, the company defaulted in the marketplace," he says.

Fund houses take a particularly close look at the cash flows of companies before investing in them. Typically, large fund houses set aside separate teams just to assess credit of companies that they could potentially invest in. ICICI Prudential Asset Management Co. Ltd has one such team of about four analysts led by Rahul Bhuskute, head- structured and credit investments. “Assessing balance sheets becomes that much more crucial in schemes such as these where we take credit risks," says Bhuskute. Further, he also highlights the importance of having the right collateral (that gets earmarked with the security that the fund invests in), like shares or land parcel which is much more marketable, especially as the MF goes down the credit rating ladder.

As some corporate bond investments might be less liquid than others, Bhuskute points out that typically fund houses keep a close eye on liquidity and also keep the option of “liquidity lines" (they borrow from banks at short-term notice) in case redemptions are higher than usual.

What should you do?

“These funds do merit a presence as a portion of your portfolio. Investors anyway invest in AA-rated non-convertible debentures and company fixed deposits. So long as these funds aren’t the only ones in your portfolio and there are other funds with better credit quality, they’re fine," says Dhawan.

Most of the corporate bond funds—except Franklin India Corporate Bond Opportunities Fund—are new and, so, lack track record.

Not all advisers are drawn towards these funds. “I don’t think investors really understand what they’re getting into. If a AAA rating focused debt fund gives you about 8.5-9.0% and a AA rating focused fund gives you about 10.5%, most investors would prefer to stick to safety as far as debt investments are concerned. We take risks through our equity funds. I think these accrual funds hide the fact that they are not as safe," says Rakesh Goidani, co-founder and director, Entrust Family Office Investment Advisors. Goidani is particularly worried about the lack of liquidity that much of these schemes’ underlying instruments suffer from.

Besides, you could find your distributor selling the scheme aggressively to you on account of the high upfront commission that some of these funds are paying to distributors, at the moment. They can afford to do so because of the high exit loads. This is because exit loads nudge the investor to stay invested for longer; the fund house knows that it would most probably earn trail fees. So the MF pays this trail fee from its own pocket to the distributor and then recovers it from the scheme as and when it gets due.

Lack of track record of most of these schemes is another drawback, though it would be foolish to just go by their—or for that matter any MF schemes’—past track record, if there is any. Many credit opportunities funds, too, are new; they were launched under a different avatar earlier, but changed their philosophy in the last two-three years. It further gets complicated because some funds’ credit opportunities get classified as an ultra short-term fund while others get classified as short-term bond funds. “You need to go beyond the name of the fund. Look at the credit risk appetite and duration of the fund," says Bhuskute.

Avoid credit opportunities funds if you haven’t invested in any MF schemes before. These should not be your first or second MF investments. Corporate bond funds can be a part of your core portfolio, though. Make sure that you match your time horizon with the fund’s modified duration to ensure that your objective matches with that of the fund. Also, watch out for high exit loads. Ultimately, invest in them only if you appreciate fully the risks that they bring along.

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