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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:

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:

1. 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.

2. Liquidity risk: These funds carry liquidity risk; that is, the fund manager may not find a buyer for the debt securities invested in.

3. 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.

Suitability:

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:

Prior to April 1, 2020, income distributed by credit opportunities funds were tax-free in the investor’s hands, since the mutual fund would pay a dividend distribution tax (DDT) before paying out the income distribution.

However, since April 01,2020, the DDT has been discontinued, and income distributed by mutual funds are taxable in the hands of investor at the rate applicable by virtue of his / her tax slab.
For units acquired prior to April 1, 2023, capital gains earned on credit opportunities funds held for less than three years were considered to be short-term capital gains, and were taxed at the rate applicable to the investor’s total income.
In contrast, capital gains earned on credit opportunities funds (acquired prior to 1st April 2023) held for more than three years were considered to be long-term capital gains, which were taxed at 20% after considering indexation (i.e. after taking the effect of inflation into account).
However, as credit opportunities will have less than 35% exposure to domestic equity shares, if you invest in a credit opportunities fund after April 1, 2023, it will fall under the category of Specified mutual funds and thus capital gains thereon will be deemed as short term capital gains irrespective of the period of holding and accordingly be taxable as per your tax slab

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.