What is Credit Risk Fund?

Introduction

One of the prime risks involved in debt fund investments is the credit risk. Credit risk refers to the risk of default by the issuer of the security in paying the principal or the interest. Low-credit rated securities have high credit risk. Hence, such securities are generally chosen by investors who have a high-risk appetite. If you are a high-risk investor and want high returns from mutual fund investments, you can consider investing in credit risk funds.

Here is everything you should know about a credit risk fund in detail:

What is credit risk fund?

As per the credit risk fund meaning, these are a type of debt mutual funds that primarily invest (nearly 65% of your investment corpus) in low-rated market securities, typically AA-rated paper.

The objective of credit risk funds is to generate high returns by investing in low-rated corporate debt funds. Such securities potentially pay higher yields (usually 2-3% returns) than other secure investments like high-rated corporate debt, government bonds, etc. However, investment in these funds also come with the risk of default and chances of a downgrade.

How does a credit risk fund generate returns?

When you invest in a mutual fund, you have the option to choose equity, debt or balanced mutual funds schemes. In equity mutual funds, you primarily invest in stocks. Debt funds invest in fixed income securities like bonds. Bonds are assigned a rating based on their credit quality, the financial standing of the issuer and the risk of default in terms of repayment of principal and interest. AAA are the highest-rated and secure bonds followed by AA, A, BBB, BB, B, etc. Credit risk funds are bonds with an AA or lower rating.

Credit risk funds invest in lower-rated bonds, and hence, the bond issuer pays a high interest to compensate for their lower credit rating. There are two methods by which credit risk funds generate returns. Firstly, these funds earn interest on the securities they hold. Secondly, since these funds invest in low-rated bonds, they create potentially high capital gains when the security rating of these funds rises. 

What is the taxation on credit risk funds?

Short-term returns (within three years of investment) from credit risk funds are subject to short-term capital gain tax. However, post three years, the returns from this fund scheme become eligible for long-term capital gain taxes of 20% with indexation benefit. There is no tax on the dividends received from capital risk fund investments. But the scheme is liable to pay a dividend distribution tax of 28.84%.

How to select credit risk funds

As specified, credit risk funds invest in low-rated securities. Hence, they have high liquidity risk. If a low-rated bond in the portfolio defaults or witnesses a downgrade, it could result in significant losses. Further, the fund manager might not be able to exit the investment due to the fixed term, which could cause depletion of your capital in years of accumulated returns.

However, if you are an informed investor and have a strong understanding of when to enter and exit the market, you can likely earn good returns in credit risk fund investments. Alternatively, to mitigate the risk, you can consider investing in a large-sized fund in this category. A large diversified portfolio reduces the loss concentration risk. Avoid credit-risk funds that are concentrated in a single sector or business group.

Further, select a credit risk fund with a low expense ratio and a fund house with sound debt portfolio management expertise and experience.

Who should invest in credit risk funds?

Even though credit risk funds are short-term investments, they carry significantly high risks. However, these funds also have the potential to offer the highest return in the debt fund category. Hence, they can be a considerable investment if you have a high-risk appetite and want to invest for a short time of 3-5 years. Moreover, if you are an informed investor and can time their exit from the market, credit risk funds can be a good investment.

Alternatively, if you are in the high-income tax slab, investing in credit risk funds can help save on taxes. You would be paying taxes on long-term capital gains of 20% instead of 30%.

However, credit risk funds are subject to market volatility. Hence, they are not ideal for weak-hearted investors. Further, if you want low-risk investments or regular income from your debt funds, you should ideally avoid credit risk funds.

Conclusion

If you have an elevated risk tolerance, you can invest in a credit risk fund. A scheme with a wide asset base is preferable because it offers a better scope of diversification and risk spreading. Learn more about how to select  credit risk funds by talking to a reputable manager with an established track record. 

Disclaimer:

ICICI Securities Ltd.( I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Centre, H. T. Parekh Marg, Churchgate, Mumbai - 400020, India, Tel No : 022 - 2288 2460, 022 - 2288 2470.  I-Sec is acting as a distributor to solicit bond related products. All disputes with respect to the distribution activity, would not have access to Exchange investor redressal forum or Arbitration mechanism. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.