Credit funds have seen large inflows over the past couple of years, as investors search for returns in a low-yield environment, but Fitch Ratings says that credit investment strategies will have to adapt to less supportive markets and manage emerging risks in the year ahead.

In a new report the rating agency says that it expects credit managers to face less supportive credit markets, and rising duration and liquidity risks. Funds that see outflows due to weaker performance will be challenged to meet redemptions as liquidity in credit markets remains low, it notes.

“After four years of significant yield compression and massive investors’ inflows, there is a rising risk of repricing driven by nominal yields or liquidity withdrawal,” says Manuel Arrive, senior director in Fitch’s fund and asset manager team. “Therefore, funds that allow flexibility in risk allocation (to manage credit beta) and selectivity (to generate credit alpha) both on the long and short side should gain traction.”

At the same time, it expects credit to remain an asset class of choice for institutional investors for regulatory and risk reasons. However, with lower return expectations, performance driven investors will demand renewed approaches in credit to stay appealing relative to equity funds, it says.

Fitch says it therefore expects more short duration, unconstrained, absolute return or target volatility credit funds to be launched. Yet, it also notes that absolute return funds “will have to find less correlated sources of return to maintain performance in less directional markets, as their correlation with traditional credit funds has increased to high levels.”

“Diversifying the sources of performance into relative value rather than directional strategies will be key in 2013,” the report says. It also sees a growing need for experience in derivatives, as the use of derivatives should increase; bottom up credit analysis skills as selective bond picking will become more important; and, technical analysis for liquidity management, macro positioning and market timing decisions.