The credit profile of these borrow ers has taken a hit on the back of weak revenues amid a sluggish demand scenario, among other problems. Most recently, the downgrade in credit rating of debt instruments issued by two companies--Amtek Auto and Jindal Steel and Power --has brought to fore the risk in portfolios of debt funds that are invested in low credit quality instruments. Several debt funds now face an uncomfortable situation, with Sebi seeking information about their investments in troubled companies. While JP Morgan AMC is facing the heat for investing in the AA rated bonds of Amtek Auto, Franklin Templeton AMC is under the scanner for its holdings in JSPL bonds. How do these developments concern you?

The debt schemes exposed to lower quality paper mostly belong to the category referred to as `credit opportunities' funds, while some are short-term bond funds. Credit funds aim to generate higher return by investing across the credit spectrum. That means these are free to invest a higher chunk of the corpus in lower rated corporate bonds (AA or lower) that yield a higher coupon. This is in sharp contrast to gilt and income funds, which invest largely in AAA-rated or equivalent paper --the safest. The difference in yields on A and AAA rated papers can be around 200-300 bps, which enables the credit opportunities funds to deliver higher returns.

These funds can also benefit whenever the underlying instrument gets a rating upgrade following an improvement in credit profile. In this event, the price of the bond increases, pushing up the NAV of the fund. However, given the exposure to lower rated paper, the risk of default by the issuing companies looms large. If the business flounders and defaults on its loan obligations, the scheme takes a hit on its portfolio.

Essentially, unlike traditional debt funds, which aim to generate returns through price appreciation in underlying bonds by timing the interest rate cycle and playing the duration strategy, credit funds are a play on the accrual strategy where returns are generated through higher yield instruments. The former are exposed to interest rate risk while the latter are faced with default risk. Besides, drying up of liquidity is also a big risk.

Most securities rated below AA are not traded actively in the market. In the event the funds faces large redemptions, it may be difficult to sell such securities at a desirable price. It may force the fund to exit from more liquid securities to provide for redemptions, enhancing the risk profile of the fund. Achieving the right balance between credit quality and liquidity position is critical in a credit opportunities fund. Interestingly, credit funds have been a big hit among investors who have lapped them up over the past year and a half. AUM in credit opportunities funds has grown 71% to ` 64,077 crore between March quarter of 2014 and June quarter this year, data from Crisil shows.

What should you do?

Risk in some debt funds towards the end of last year, when the exposure to A-rated bonds was at a five-year high. We argued that investors need to ascertain the risk involved before investing in some of these funds. It is clear now that some fund houses have been too flexible in their credit standards in the hunt for higher yields.  We have seen a steep move down the credit curve.Fund houses have been chasing higher yields faced by competitive pressures.

Most of these fund houses went for low rated paper on the assumption that the economy will turn around faster and the credit rating of these companies will be upgraded. However, that call has gone wrong in some cases. Fresh inflows into credit funds to slow down in the coming months. Also, given that the inter est rates are expected to come off, investor preference will shift to traditional funds.

However, this doesn't mean that credit opportunities funds should be junked. The head of a top mutual fund house says investors should not see this as an industry-wide malaise, but as a fund house-specific issue.  The focus is not to go down the credit curve in our credit funds but to invest in instruments of companies which show potential for credit upgrade. As long as your objective is aligned to the fund's mandate, it remains a good bet," he says. However, these funds remain purely for those investors who have the capacity to take on higher risk.