Credit Risk Funds
Credit risk funds are a type of debt fund that allocates at least 65% of their investments to bonds with credit ratings of 'AA' or lower. But why would anyone choose to invest in bonds that are considered riskier?
In this article, we will explore what credit risk funds are, how they operate, and what advantages and risks come with investing in them.
What are Credit Risk Funds?
According to SEBI regulations, a credit risk fund is a type of debt fund that primarily invests in lower-rated bonds (those with 'AA' ratings or below). This debt fund generates returns through two main channels:
Interest Payments: Credit risk funds invest in debt securities that provide periodic interest. This interest forms part of the fixed income generated by the fund and it is usually paid quarterly or semi-annually. Fund managers select lower-rated bonds with higher interest rates, balancing credit quality with potential returns.
Capital Appreciation: When the credit rating of debt securities improves, its market value (NAV) rises, allowing credit risk funds to generate capital gains. Fund managers actively look for such opportunities to benefit from potential upgrades in credit quality.
Despite the potential for higher returns, credit risk funds expose investors to higher credit risk as the bonds carry a greater risk of default.
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What is Credit Risk?
Debt funds generally carry less risk compared to equity mutual funds, but they are not entirely risk-free. One of the key risks involved is credit risk, also known as default risk. This refers to the possibility that the issuer of the debt may fail to pay interest or return the principal amount.
To assist investors in evaluating these risks, rating agencies like CRISIL and ICRA in India assign ratings to securities, ranging from 'AAA' to 'D.'
A higher rating suggests low default risk. Below are the ratings given by CRISIL and ICRA.
| Rating for Debt Securities | CRISIL | ICRA |
| Highest Safety | CRISIL AAA | ICRA AAA |
| High Safety | CRISIL AA | ICRA AA |
| Adequate Safety | CRISIL A | ICRA A |
| Moderate Credit Risk | CRISIL BBB | ICRA BBB |
| Moderate Default Risk | CRISIL BB | ICRA BB |
| High Default Risk | CRISIL B | ICRA B |
| Very High Default Risk | CRISIL C | ICRA C |
| Default | CRISIL D | ICRA D |
Why Do Investors Choose Lower-Rated Securities?
Investors opt for riskier, lower-rated securities because they offer the potential for higher returns. Although these bonds carry more risk, they also tend to provide higher interest rates. Credit risk funds aim to capitalise on this by investing in low-rated corporate bonds to achieve higher returns for their investors.
Features of Credit Risk Mutual Funds
A credit risk fund appeals investors who have a higher risk appetite and are looking for better returns from debt investments.
Focus on Lower-Rated Bonds: Unlike traditional debt mutual funds that invest in higher-rated bonds, credit risk funds invest in bonds rated 'AA' and below. These bonds carry relatively higher credit risk, which means there is a greater chance that the issuer might default. However, these bonds also offer higher potential returns as compensation for taking on more risk.
Higher Interest Rates: Because of the higher credit risk, the lower-rated bonds in credit risk funds offer better interest payments than safer, higher-rated bonds.
Diversified Portfolio: To manage the risks associated with investing in lower-rated bonds, fund managers spread investments across different issuers. This diversification helps reduce the impact of any single bond defaulting on the overall portfolio.
Advantages of Investing in Credit Risk Mutual Funds
Despite the higher risks, credit risk funds come with several advantages that make them appealing to certain types of investors.
Higher Returns: Since credit risk funds invest in lower-rated bonds, they tend to offer higher interest rates compared to traditional debt funds that focus on safer higher-rated bonds. This makes them appealing to investors who are willing to accept more risk for better returns.
Capital Appreciation: When the lower-rated bonds in a credit risk fund receive a credit rating upgrade, the value of those bonds increases, leading to capital gains. This allows investors to profit not just from interest but also from the potential for higher bond prices.
Diversification: Credit risk funds provide diversification by spreading investments across various corporate bonds. This diversification helps to mitigate some of the risks associated with individual bond defaults.
Steady Interest Payments: Investors in credit risk funds benefit from regular interest payments. While the risks are higher, the interest payments can provide a consistent income stream for those who invest in these funds.
Disadvantages of Investing in Credit Risk Funds
While the returns may be attractive, credit risk funds also come with their fair share of downsides.
Higher Credit Risk: These funds invest in bonds with a higher risk of default, increasing the likelihood of losses.
Market Volatility: Credit risk funds are sensitive to economic cycles, making them more volatile compared to other debt mutual funds.
Potential Capital Losses: In case of a bond downgrade or default, investors may face significant losses, especially during economic downturns.
Interest Rate Sensitivity: Changes in interest rates can affect the price of bonds held in the fund, impacting returns.
Who Should Invest in a Credit Risk Mutual Fund?
Not all investors are suited for credit risk mutual funds. So, who should consider investing in them?
- Credit risk mutual funds are ideal for investors with a higher risk appetite and those looking for better returns from debt investments.
- Individuals who have an investment horizon of 2-3 years and are comfortable with the idea of relatively higher credit risk should consider these funds.
- It's also a good choice for investors looking to diversify their portfolios and earn potentially higher returns.
Factors to Consider Before Investing in a Credit Risk Fund
Before diving into a credit risk fund, several critical factors should be evaluated to make an informed decision.
Credit Quality: Review the credit quality of the debt securities held by the fund, focusing on their ratings.
Risk Appetite: Assess whether you have a 'Very High' risk tolerance.
Investment Horizon: Ideally, these funds are suitable for those with a short-term investment horizon of at least 2-3 years.
Market Conditions: Consider the current economic and interest rate environment, as this can affect both returns and risk levels.
Fund Managers: The experience and track record of the fund manager are critical since active management plays a crucial role in minimising risks.
Taxation of Credit Risk Mutual Funds
The taxation of Credit Risk Funds follows the same structure as other debt funds, with tax treatment varying based on the investment date and the holding period. Here's how it works:
Invested Before April 1, 2023:
Short-Term Capital Gains (STCG): If units are held for less than 24 months, any gains realised from selling these units are classified as short-term capital gains. These gains are taxed according to the investor's applicable income tax slab rate.
Long-Term Capital Gains (LTCG): For units held for more than 24 months, the gains are classified as long-term capital gains and are taxed at 12.5%.
Invested After April 1, 2023:
For all investments made on or after April 1, 2023, both STCG and LTCG are taxed at the investor's applicable income tax slab rate, irrespective of the holding period. This means that the distinction between short-term and long-term gains no longer applies, and all gains are subject to the investor's marginal tax rate.
How to Invest in Credit Risk Mutual Funds
You can invest directly in a credit risk fund through the asset management company's website, or you can use INDmoney to invest online in the best credit risk fund in a few easy steps:
- Open the INDmoney app and log in with your credentials.
- Go to the "Mutual Funds" section within the app.
- Use the filter options to select "Credit Risk Mutual Funds" to see the available options.
- Choose between a lump sum investment or a Systematic Investment Plan (SIP) for ongoing investments.
- Enter the amount you wish to invest and confirm the transaction.
Frequently Asked Questions
A credit risk fund is a type of debt mutual fund that invests at least 65% in debt instruments, primarily in lower-rated bonds ('AA' and below) to generate higher returns through interest payments and potential capital gains.
Investors with a 'Very High' risk appetite and a short-term investment horizon of at least 2-3 years should consider investing in credit risk funds for higher returns.
A credit rating assesses the creditworthiness of a company or business, indicating how likely it is to repay its debts. These ratings are represented by symbols like AAA, AA, or BB, with higher ratings (like AAA) showing a low risk of default and lower ratings (like BB or below) indicating higher risk.
A credit score, however, is a number (typically ranging from 300 to 900) assigned to individuals by credit bureaus. It reflects an individual's credit history and repayment behavior. Lenders use this score to determine a person's eligibility for loans or credit cards.
Credit ratings are important because they help investors and lenders assess how risky it is to lend money to a company or government. A high credit rating (like AAA) shows that the borrower is very likely to repay its debt, which makes it safer for investors to lend money. A lower rating, on the other hand, means there's a greater chance of the borrower defaulting, or not paying back their debt, which increases risk for investors.
Credit risk in mutual funds refers to the possibility that a bond issuer within the fund may fail to make interest payments or repay the principal amount. In credit risk funds, which invest in lower-rated bonds, this risk is higher.