Credit Risk Fund

Credit Risk Mutual Funds are debt funds that invest in low-credit quality debt securities. Explore credit risk fund meaning, how it works, features, taxation, and more in this blog.
Credit Risk Fund
4 mins
30-April-2024

A credit risk fund is a type of debt mutual fund that invests in bonds and debentures of companies with low credit ratings. The aim of a credit risk fund is to earn higher returns by taking higher risks. In this article we will focus on what are credit risk funds, how credit risk funds work, their features and much more.

What are credit risk mutual funds?

Credit Risk Mutual Funds are debt funds specializing in low-credit quality debt securities, entailing elevated risks due to investments in such instruments. Typically, securities with ratings below AA offer higher interest rates, reflecting increased credit risk. Fund managers may strategically select securities poised for rating upgrades, potentially enhancing the fund's NAV.

How do credit risk funds work?

Here is how credit risk mutual funds work:

  • Credit risk funds buy securities that have lower ratings or are unrated by credit rating agencies.
  • These securities offer higher interest rates than those with higher ratings, as they have a higher chance of defaulting or delaying payments.
  • Credit risk funds benefit from capital appreciation when the ratings of these securities improve or when the market perceives them as less risky.
  • Credit risk funds also earn regular income from the interest payments of these securities.
  • Credit risk funds are subject to interest rate risk, credit risk, and liquidity risk.

Features of credit risk mutual funds

Listed below are some features of credit risk mutual funds:

  • Credit risk mutual funds have a minimum investment horizon of 3 years to benefit from the long-term performance of low-rated securities.
  • Credit risk mutual funds have a moderate to high risk profile, as they are exposed to the possibility of defaults or downgrades of the securities they hold.
  • Credit risk mutual funds have a high potential for returns, as they can generate capital gains and interest income from low-rated securities.
  • Credit risk mutual funds have a diversified portfolio of securities across different sectors, maturities, and ratings to reduce the overall risk.
  • Credit risk mutual funds have a low correlation with other debt funds and equity funds, as they are influenced by different factors.
  • Credit risk mutual funds have a dynamic asset allocation strategy, as they can change the proportion of low-rated and high-rated securities depending on the market conditions.
  • Credit risk mutual funds have a high expense ratio, as they incur higher costs for research, analysis, and monitoring of low-rated securities.

Who should invest in a credit risk mutual fund?

  • Investors aiming for enhanced returns in fixed-income investments: If you seek better returns compared to typical fixed-income options, a credit risk fund may align with your investment goals.
  • Investors with a high risk tolerance: Given their higher risk and volatility, credit risk funds are suitable only for those comfortable with such risk levels. Opt for them if you're willing to withstand market fluctuations.
  • Investors with a medium-term investment horizon: If your investment timeframe spans 2 to 3 years and you're open to higher risk, credit risk funds could be appropriate. However, they're not advisable for those seeking low-risk, stable debt schemes.

Risks of investing in credit risk funds

  • Default risk: This is the risk of the issuer of the security failing to repay the principal and/or interest on time. Default risk is higher for low-rated securities, as they have a lower creditworthiness and a higher probability of defaulting or delaying payments. A default can result in a loss of capital and income for the fund and its investors.
  • Downgrade risk: This is the risk of the credit rating of the security being lowered by the rating agencies due to a deterioration in the financial condition or performance of the issuer. A downgrade can negatively affect the market value and liquidity of the security, as well as the reputation and returns of the fund.
  • Liquidity risk: This is the risk of the fund not being able to sell the security at a fair price or in a timely manner due to a lack of buyers or market conditions. Liquidity risk is higher for low-rated securities, as they have a lower demand and a higher spread in the market. A low liquidity can hamper the fund’s ability to meet redemption requests or rebalance the portfolio.
  • Interest rate risk: This is the risk of the market interest rates changing and affecting the value and returns of the fund. Interest rate risk is lower for credit risk funds than other debt funds, as they invest in securities with shorter maturities and higher yields. However, interest rate risk still exists, as the fund’s returns can fluctuate depending on the direction and magnitude of the interest rate movements.

Factors to consider before investing in credit risk mutual funds in India

Listed below are some factors to consider before investing in credit risk mutual fund:

  • Investment objective: Credit risk mutual funds are suitable for investors who have a high risk appetite and are looking for higher returns than other debt funds.
  • Investment horizon: Credit risk mutual funds require a long-term investment horizon of at least 3 years, as they are subject to high volatility and uncertainty in the short term.
  • Fund performance: Credit risk mutual funds should be evaluated based on their past performance, consistency, and risk-adjusted returns over different time periods. However, past performance is not indicative of future performance.
  • Fund manager: Credit risk mutual funds should be managed by experienced and skilled fund managers who have a good track record of selecting and managing low-rated securities.
  • Fund size: Credit risk mutual funds should have a sufficient fund size to ensure adequate diversification and liquidity of the portfolio.
  • Credit quality: Credit risk mutual funds should have a balanced mix of low-rated and high-rated securities to optimise the risk-return trade-off.
  • Exit load: Credit risk mutual funds may charge an exit load if the units are redeemed before a specified period, usually 1 year.

Taxation on credit risk funds

Here are some taxation rules which apply on credit risk funds:

  • Credit risk funds are taxed as debt funds for income tax purposes.
  • The capital gains from credit risk funds are classified as short-term or long-term depending on the holding period.
  • Short-term capital gains (for gains of up to 3 years) are taxed at the investor’s slab rate, while long-term capital gains (LTCG) are taxed at 20% with indexation.
  • Indexation is a method of adjusting the cost of acquisition of the units to account for inflation, which reduces the taxable capital gains.
  • Credit risk funds are also subject to tax deducted at source (TDS) at 10% on the dividend, which can be claimed as a refund if the investor’s tax liability is lower.

How to invest in Credit Risk Funds with Bajaj Finserv

Here is a step-by-step guide to invest in mutual funds on the Bajaj Finserv Mutual Funds platform:

  • Step 1: Visit the Bajaj Finserv website or download the app from Google Play Store or App Store
  • Step 2: Navigate to 'Investments' and click on 'All Investments' on the home page
  • Step 3: Click on 'Mutual Funds' icon
  • Step 4: Click on 'Explore Funds'. You will be redirected to the mutual funds listing page
  • Step 5: Filter by scheme type, risk appetite, returns, etc. or choose from the top performing funds list
  • Step 6: All the mutual funds of the particular category will be listed, along with the minimum investment amount, annualised return, and rating
  • Step 7: Click on 'Invest Now'
  • Step 8: Enter your mobile number and sign in using the OTP
  • Step 9: Verify your details using your PAN, date of birth. If your KYC is not complete, then you will have to upload your address proof and record a video
  • Step 10: Enter your bank account details
  • Step 11: Upload your signature and provide some additional details to continue
  • Step 12: Choose and select the mutual fund that you want to invest in
  • Step 13: Choose whether you want to invest as SIP or lumpsum and enter the investment amount. Click on ‘Invest Now’
  • Step 14: Select your payment mode i.e., net banking, UPI, NEFT/ RTGS
  • Step 15: Once your payment is done, the investment will be complete

Your investment will start reflecting in your portfolio within 2-3 working days.

Conclusion

Credit risk funds are suitable for investors who have a high risk appetite and a long-term investment horizon. They can offer higher returns than other debt funds, but they also carry higher risks. Investors should carefully assess their risk tolerance, investment objective, and fund performance before investing in credit risk funds.

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Frequently asked questions

How do credit risk funds generate returns?

Credit risk funds generate returns by investing in low-rated debt securities that offer higher interest rates and potential rating upgrades.

Who should invest in credit risk funds?

Credit risk funds are suitable for investors who have a medium-to-high risk tolerance and want to invest in debt funds for at least 3-5 years.

What is the difference between a corporate bond fund and a credit risk fund?

Corporate bond funds invest at least 80% of their money in high-rated corporate bonds, while credit risk funds invest at least 65% in low-rated corporate bonds.

Is a credit risk fund a debt fund?

Yes, a credit risk fund is a type of debt fund that lends money to borrowers and earns interest income and capital gains or losses.

What is interest rate risk in debt funds?

Interest rate risk is the potential that a change in overall interest rates will reduce the value of a bond or a debt fund.

What are the advantages of credit risk funds?
  • Higher potential returns: Offer the chance for higher returns compared to traditional debt funds due to the higher interest rates on lower-rated bonds.
  • Active management: Fund managers seek undervalued bonds with potential for credit rating upgrades, which can boost the fund's value.
Is a credit risk fund good?

Credit risk funds can be suitable for investors seeking higher potential returns and willing to tolerate a greater risk of default compared to traditional debt funds. Carefully assess your risk tolerance before investing.

Which is the highest risk fund?

It depends on the specific fund's investment strategy. Generally, credit risk funds are considered riskier than traditional debt funds due to the lower credit quality of their holdings. However, some equity funds or sector-specific funds may carry even higher risk.

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