What is a Credit Risk Fund?

Here’s a quick guide to credit risk mutual funds, which are a type of high-risk, high-return investment vehicle.
Credit Risk Fund
4 mins
04 Feb 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.

How do credit risk 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

  • 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.

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

  • 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

  • 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.

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.

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.

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