Gilt funds and credit opportunities funds play on different aspects of the bond market. The former invest in longer maturity government securities that witness high capital appreciation in a softening interest rate environment.The latter focus on interest accrual--the income from coupon payments on underlying bonds--and typically invest in corporate bonds with a higher yield but lower rating (AA or below). Credit funds can also make some returns from capital gains, by looking for mismatches in the current rating of a bond vis-a-vis its fundamentals. If the credit rating of the underlying bond gets upgraded, due to the improving fundamentals of the underlying company, it results in appreciation in the bond's market price, boosting the fund's return. However, this tends to account for a smaller portion of the total return from these funds.

The cost of higher returns

With the interest rate easing all but over, the performance driver for debt funds has shifted from bond price appreciation to income accrual. Besides, what has worked in favour of credit funds is the lower volatility in returns, compared to gilt funds.

Several funds in the category have clocked more than 10% return over the past one year. However, they have taken greater risk to generate these returns, as is indicated by their exposure to lower-rated instruments (see table). BOI AXA Corporate Credit Spectrum and Franklin India Dynamic Accrual have invested 45% and 51% of their portfolio, respectively, in bonds rated `A and below'. The category's average exposure to this segment is around 31%. But while BOI AXA has also taken a healthy exposure of 22% in high safety AAA-rated bonds, Franklin India Dynamic has negligible investment in this segment. AAA rating indicates highest level of safety (little risk of default), while A and lower rating signifies a much higher default risk. Baroda Pioneer Credit Opportunities has loaded up on relatively safer AA rated instruments, comprising 56% of its portfolio, compared to the category average of 50%. Meanwhile, Aditya Birla Sun Life Corporate Bond holds around 40% of its portfolio in AAA-rated instruments--peers' holdings in the segment is just about 20%.

Why credit quality is a concern

The composition of the underlying portfolio of credit funds assumes great significance in the light of numerous instances of corporate loan defaults and credit rating downgrades. When underlying bonds witness rating downgrade, their price falls sharply, eroding the overall return from the debt fund. Companies may face ratings downgrade owing to deteriorating fundamentals--usually high debt levels and limited traction in cash flows.

Recently, companies such as IDBI Bank and Reliance Communications have seen ratings downgrades. With the credit profile of debt-riddled firms remaining weak, credit funds, in their bid to deliver high returns, are playing a high-risk game. Many credit funds are now carrying higher credit risk than they started with or intended to carry a few years ago.

The corporate credit upgradedowngrade ratio remains unfavourable. The terms and conditions governing these bonds have become more complex. And the liquidity position in these funds remains untested in the event of redemption pressure. Although credit opportunities funds are mostly immune to unfavourable yield movement, the risk of default in underlying compa nies continues to be high. "Unlike in other categories, like dynamic bond funds, the risk is far less visible in credit opportunities funds.In the event of a default, the hit may be significant. Investors should not get swayed by the higher returns being offered by this segment. Lack of opportunity in traditional debt funds that play on interest rate movements does not warrant a complete switch to the credit funds. If you wish to play the credit risk, avoid going for the overly aggressive funds that chase higher yields with con centrated exposure in very low rated instruments. If already invested in credit funds, rebalance in favour of cleaner credit at this juncture