Credit risk is one of the primary risks of investing in debt funds. It is the risk of default of the issuer of the security in repaying the principal and/or interest. Credit risk is higher with low-quality securities and therefore most conservative investors prefer mutual funds which invest only in high-credit quality debt securities. However, there is a type of debt fund which invests in low-credit quality securities – Credit Risk Fund. Here, we will explore credit risk funds and talk about everything that you need to know about them before investing.
What is a Credit Risk Mutual Fund?
Credit Risk Mutual Funds are debt funds which invest in low-credit quality debt securities. These funds have higher risks since they invest in low-quality instruments.
Why would a fund invest in securities with low credit ratings?
The answer is simple. Securities with a low credit rating tend to offer higher interest rates. Usually, instruments with a credit rating below AA are considered to carry a higher credit risk. The fund managers of Credit Risk Funds also choose securities which might get a boost in rating (as per their analysis). This can have a positive impact on the NAV of the fund.
Features of Credit Risk Mutual Funds
Here are some salient features of credit risk mutual funds:
- They are tax-efficient for investors in the highest tax slab since Long Term Capital Gains (LTCG) are taxed at 20% while their tax slab rates are 30%.
- These funds have more liquidity risks.
- The fund manager plays an important role in the performance of the fund. He chooses the low-rated securities to invest in!
How do Credit Risk Mutual Funds work?
Credit Risk Funds invest in debt securities and money market instruments which have a low credit rating since such instruments tend to offer higher interest rates. Also, when the rating of a security is upgraded, the fund benefits. Credit Risk Funds have lower-interest-rate risks and the fund manager ensures that he keeps the average credit quality of the fund within control and the default probability relatively low. Usually, credit risk funds tend to offer 2-3% higher returns than risk-free debt investments.
Should you invest in Credit Risk Mutual Funds?
Credit risk funds have a higher risk as compared to other debt schemes. While the fund manager anticipates an upgrade in the credit rating of an underlying security, there is a possibility of a further downgrade of a low-rated instrument. This can have a huge impact on the performance of the fund. Hence, you must consider investing in these funds if you have a medium-to-high risk tolerance and want to invest in debt funds.
Factors to consider before investing in Credit Risk Mutual Funds in India
Here are some important aspects that you must consider before investing in credit risk funds in India:
- Creating your own credit risk investment portfolio can be counterproductive as one needs to consider many factors apart from the credit rating of an instrument before investing. Hence, it is advisable to invest via a credit risk mutual fund.
- Look for credit risk funds with a large corpus. This allows the fund manager to diversify across various instruments and reduce the risks.
- Don’t forget to check the expense ratio of the fund.
- Research the fund manager and look for one with experience in a similar role.
- Choose a credit risk fund which is diversified across various securities.
- Usually, investors don’t invest more than 10-20% of their portfolio in a credit risk fund. Ensure that you check your investment plan before investing.