Average credit quality in mutual funds

The average credit quality in mutual funds refers to the collective assessment of the creditworthiness of the bonds or debt instruments held within the fund's portfolio, indicating the level of risk associated with potential defaults or downgrades.
Average credit quality in mutual funds
3 min
05-July-2024

Average credit quality in mutual funds refers to the ability of the funds to pay regular interest and repay the principal amount at the time of maturity. When investors consider investing in mutual funds, they have to choose between numerous types of mutual funds, such as equity and debt. While equity mutual funds invest in stocks of various companies, debt mutual funds majorly invest in bonds issued by corporations and the government. However, as debt mutual funds invest in multiple bonds to create a portfolio, investors must ensure that the portfolio has quality bonds that will not default on interest payments and principal repayments.

Investors can review the creditworthiness of a debt mutual funds portfolio through the attached average credit quality. This blog will help you understand the average credit quality in mutual funds and how you can use it to develop a better mutual fund investment approach.

What is the average credit quality in mutual funds?

Average credit quality in mutual funds is a metric that measures the average creditworthiness of the portfolio based on the individual credit ratings of included bonds. The mutual fund's average credit quality is generally attached to a debt mutual fund that primarily invests in private or government bonds. Investors who want to invest in debt mutual funds can see the prospectus of the mutual fund scheme, which contains the average credit rating for the whole portfolio.

Average credit rating in mutual funds represents how much credit risk is associated with the debt mutual fund portfolio. If the average credit quality is high, it means that the mutual fund portfolio is less likely to default on interest payments and principal repayments. If it is low, the default risk increases.

How does average credit quality work?

When issuers such as a company or a government issue bonds to raise money, credit rating agencies such as CRISIL evaluate the creditworthiness of the issuer. Creditworthiness refers to the ability of the issuer to pay regular interest and repay the principal amount at the time of maturity without defaulting even a single time. Such credit rating agencies give a credit rating to every bond to allow investors to know how much default risk there is.

When a mutual fund manager creates a new debt mutual fund scheme, the pooled investor money is invested in numerous private and government bonds. Since there are multiple bonds with different weightage in a single portfolio, it becomes difficult for investors to analyse every single bond based on their individual credit rating.

Hence, the credit rating agencies take the average of all the credit ratings given to the bonds included in the portfolio. The average is known as average credit quality and provides an overview of the credit quality of the whole portfolio. Furthermore, credit rating agencies evaluate other factors, such as the fund house’s portfolio size, internal documents, past performance, public filings, etc., to give the whole portfolio an average credit quality score.

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Advantages of average credit quality in mutual funds

Here are the advantages of average credit quality in mutual funds:

  • Risk assessment and management: Investors can view the average credit quality and determine whether the mutual fund scheme contains high or low credit risk. The average credit quality helps investors avoid investments that come with high credit risk as they can better execute risk assessments.
    Furthermore, investors can use the average credit quality in mutual funds to make informed decisions about the risk level they are comfortable with, aligning their investment choices with their risk appetite.
  • Portfolio stability: Funds with higher average credit quality generally provide more stable and predictable returns to investors. This is because a portfolio with a higher average credit quality is less likely to face defaults from individual issuers. Furthermore, they add to steady and stable returns as they are less volatile compared to a portfolio with a lower average credit quality.
  • Less default risk: A mutual fund portfolio with a higher average credit quality is more likely to pay regular interest and repay the initial principal amount without default. Hence, investors can know beforehand the level of default risk attached to a mutual fund and make decisions accordingly.
  • Diversification benefits: Investors can analyse the average credit quality of various mutual fund portfolios and invest in a mix of such mutual funds with different average credit qualities. This can help in effective diversification as bonds with a lower credit rating generally provide a higher interest rate. Hence, by investing in a mix of mutual fund schemes with different average credit ratings, investors can spread the overall risk and earn higher potential returns.
  • Better comparison: Investors can use a mutual fund's average credit quality to compare it with another mutual fund scheme. Through extensive comparison, investors can choose the most suitable mutual fund schemes based on their attached average credit quality.

Method of calculating the credit quality of a mutual fund

Every credit rating agency has a distinctive method for calculating the credit quality of a mutual fund. However, the most common way to calculate the average credit quality of a mutual fund is by calculating the average of the ratings attached to individual bonds included in the mutual fund portfolio.

Usually, credit rating agencies provide average credit quality ratings to mutual funds based on alphabets, such as AAA, AA, A, BBB, etc. While AAA means that there is no default risk, the lower the ratings, the higher the default risk.

How do average credit quality ratings help fund management companies?

Along with helping investors assess the default risk levels of a mutual fund portfolio, average credit quality ratings also help fund management companies. Fund managers can evaluate the average credit quality of a mutual fund portfolio they have created to know the associated default risk. This helps them maintain an appropriate level of risk in their portfolio while ensuring they achieve the set investment goals.

The fund management company can also review the average credit quality of their funds to compare their performance against other mutual fund schemes, helping them create a better portfolio for the investors. Furthermore, mutual fund management companies can also attract various types of investors by highlighting the average credit quality. For example, if the average credit quality is high, the fund can attract risk-averse investors. On the other hand, if it is lower, it can attract risk-tolerant investors.

How are bonds given credit ratings?

Various credit rating agencies give bonds ratings based on the creditworthiness of the issuer. For example, if a bond is issued by the government, its credit rating will be higher as there is a negligible chance of the government defaulting on interest payments and principal repayment. However, if the bond is issued by a company that does not have a positive cash flow, the default risk becomes high, and the credit rating agency rates the bond with a lower rating.

Bonds with a higher credit rating generally pay a lower interest rate as they are low-risk and safer. On the other hand, bonds with a lower credit rating pay a higher interest rate to attract investors to buy the bonds even when there is a default risk.

CRISIL ratings for mutual fund schemes

Here are ratings given by CRISIL to various mutual funds:

Short-term mutual fund schemes Long-term mutual fund schemes
CRISIL A1mfs CRISIL AAAmfs
CRISIL A2mfs CRISIL AAmfs
CRISIL A3mfs CRISIL Amfs
CRISIL A4mfs CRISIL BBBmfs
  CRISIL BBmfs
  CRISIL Bmfs
  CRISIL Cmfs


ICRA mutual fund credit risk ratings scale

Here is how the ICRA credit rating agency rates mutual funds:

Short-term mutual fund schemes Long-term mutual fund schemes
ICRA A1mfs ICRA AAAmfs
ICRA A2mfs ICRA AAmfs
ICRA A3mfs ICRA Amfs
ICRA A4mfs ICRA BBBmfs
  ICRA BBmfs
  ICRA Bmfs
  ICRA Cmfs


What does a mutual fund credit average credit quality tell investors?

The average credit quality in mutual funds tells investors about the associated credit risk of the overall mutual fund portfolio. A higher average credit quality means that the portfolio and all the issuers of bonds included in the portfolio will pay the interest and repay the principal amount at the predetermined date without any delay or default.

The average credit quality also tells the investors about the level of stability in a mutual fund portfolio. Investors who want to invest with the lowest risk possible can choose mutual funds with the highest average credit quality rating, such as AAA. However, investors who want to earn more through interest payments can invest in mutual funds that have a lower average credit quality rating as they pay more interest than mutual funds with a higher average credit quality rating.

Conclusion

The average credit quality is a rating given to mutual fund schemes that have debt instruments such as bonds in their portfolio. Credit rating agencies give every debt mutual fund scheme an average credit quality rating by calculating the average of all the individual credit ratings of the included debt instrument in the portfolio. You can look at the average rating quality rating to determine the level of default risk attached to a specific mutual fund scheme and invest accordingly.

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