Credit risk funds are a type of debt fund. They invest at least 65% in bonds issued by companies with lower credit ratings. Be aware that these companies have a higher chance of defaulting on their loans. Thus, to attract investors, these companies offer higher interest rates on their bonds. The higher interest rates compensate investors for the increased risk of investing in companies that might not be as financially stable. In turn, these funds also offer higher returns but come with higher risk.
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.
Advantage of credit risk mutual funds
Generally, credit-risk mutual funds provide higher returns but with higher risk. They are suitable for investors looking to diversify their portfolios and earn more than traditional debt funds. For more clarity, let’s study some of their major advantages:
Opportunity for higher returns
Credit risk funds invest in high-risk debt securities offered by companies with lower credit ratings. Usually, these securities offer higher interest rates to compensate for their risk. It is worth mentioning that if the credit ratings of these companies improve, the value of their bonds can increase significantly. This leads to high capital gains for investors.
Thus, credit risk funds can offer returns higher than many other debt funds, sometimes by as much as 3%.
Expertise and risk exposure
Credit risk funds expose investors to high-risk debt securities, which they might not choose on their own due to the associated risks. However, by investing in these funds, investors benefit from the expertise of professional fund managers who carefully select and manage the portfolio. These managers try to align their investment strategies with the mid to long-term financial goals of investors. Thus, in a way, fund managers better balance risk and the expected reward.
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.
How do credit risk funds generate returns?
Credit risk funds generate returns by investing in bonds from companies with lower credit ratings, which are considered riskier. Since these companies have a higher chance of default, they must offer higher interest rates to attract investors. When investors buy these bonds, they earn this higher interest.
Additionally, if the financial situation of these companies improves and their credit ratings are upgraded, the value of the bonds can increase. This results in capital gains and provides investors with returns that are higher than those from safer debt funds. Thus, credit risk funds can offer both high interest and expected price gains.
