Credit Risk Mutual Funds: Meaning, Investment Process, and Who Should Invest

Credit risk mutual funds are a great investment option with potentially higher returns as compared to other debt funds. Since it better suits the investors who have a high-risk appetite, it becomes an ideal investment option for experienced and seasoned investors who are willing to take extra risks to earn more returns.

Read on to know more about the Credit Risk Mutual Funds:

What is a Credit Risk Mutual Fund?

Credit risk mutual funds are a class of open-ended debt schemes that invest in lower rated corporate bonds that usually offer high yields. However, since these funds invest in low-quality bonds, they are associated with a higher risk. Credit risk is the risk of default that an investor takes on, if the issuer of a fixed-income securities is unable to pay back the interest or principal amounts on time.

One might wonder why a fund manager would willingly invest in a low-quality instrument. The answer is that securities with a low credit rating offer a higher interest rate to make up for their high risks.

Financial experts consider the instruments that carry a credit rating below AA+ to be of higher credit risk. Often, fund managers of credit risk funds select those securities that they feel would see a rise in ratings. If their calls on the corporate papers go right, it will result in higher returns. However, it may not always be the case.

Features of Credit Risk Mutual Funds

• According to the Securities Exchange Board of India (SEBI), credit risk mutual funds have to mandatorily allocate a minimum of 65% of their entire fund corpus to corporate bonds with a rating below AA+.
• Low-rated corporate bonds offer high coupon rates to compensate for their higher levels of risks. As a result, mutual funds that invest in these bonds have the potential to yield higher returns as compared to investing in a single corporate bond
• The best credit risk mutual funds invest in well-performing companies. These mutual funds benefit greatly when there is an upgrade in the ratings of debt securities.
• Fund managers of credit risk funds are responsible for choosing the securities in the investment portfolio.Credit risk mutual funds are associated with high liquidity risks.

How Does a Credit Risk Mutual Fund Work? 

As mentioned above, credit risk funds invest a minimum of 65% of their total funds in corporate debt securities with a rating of AA or lower. Corporate bonds are assigned credit ratings by credit rating agencies based on the creditworthiness of the issuer. The highest bond rating is AAA, followed by AA, A, BBB, BB, B and so on, up to D.

These funds deliberately invest in money market instruments and debt securities with a low credit rating as they offer high-interest rates. Once the ratings of the underlying securities improve, the credit risk fund generates high capital gains for the investors. 

When a borrower fails to make the necessary payment with respect to an underlying security, it has a negative impact on its credit rating. It results in lower capital gains for investors. To minimise the losses from defaults, a credit risk fund may invest in a lot of securities and hold bonds with shorter maturity periods.

The interest payments made by the borrower are another source of income for credit risk funds. It is the responsibility of the fund manager to check and maintain the overall credit rating of the scheme. 

Generally, credit risk funds generate returns 2% – 3% higher than risk-free debt funds. 

What Are the Benefits of Investing in Credit Risk Funds? 

• These mutual fund schemes usually generate higher returns than FD at banks. 
• In order to compensate for the high risks associated with these funds, the underlying corporate bonds offer a high-value coupon rate.
• Although there are risks associated with these funds, they are usually lower compared to equity investments.
• Investors in the highest tax bracket (30%), can reduce their tax liability by investing in these funds for over 3 years. The tax rate is 10% less than that for traditional investments, with the added benefit of indexation, which lowers the taxes further.

What are the Disadvantages of Credit Risk Funds? 

There are a few disadvantages of investing in credit risk mutual funds:

• Lower liquidity: If the credit rating agencies downgrade these funds, it becomes difficult to liquidate them. For instance, defaults by corporations like DHFL, Vodafone and IL&FS group have caused major credit issues in India. This has further resulted in a reduction of investors’ confidence, leading to high redemption, which is difficult for credit risk funds to fulfil. 
• High risk: There is an increased risk of default of interest or principal. Moreover, the downgrading of underlying securities may lead to losses for investors. 
• Not meant for all investors: Credit risk funds are not for all types of investors. Risk-averse and conservative investors should stay away from this high-risk investment option. 

Who Should Invest in Credit Risk Mutual Funds?

• Risk Appetite: Credit risk mutual funds are associated with high risk and volatility. So, it is a more appropriate investment option for investors with medium-high risk tolerance. 
• Investment Horizon: Additionally, it is an appropriate investment option for an investor comfortable with a medium to long-term time horizon.

Taxability of Credit Risk Mutual Funds 

• The Income Tax Department treats credit risk mutual funds the same as any other debt funds, and has similar rules for taxation.
• If an investor sells the units within three years of their investment, the capital gains are deemed as short-term capital gains (STCG). The tax on such gains will be applicable as per the investor’s income tax slab rate.

If an investor sells the units after three years of investment, long-term capital gains (LTCG) tax will be applicable to it. These gains are taxed at a flat rate of 20% after indexation.

Important Factors to Consider before Investing into a Credit Risk Fund:

• Financial plan

Investors need to identify their financial goals and make a plan accordingly if they wish to invest in these mutual fund schemes.

• Fund managers

People must evaluate the past performances of fund managers to assess their expertise. This is important because the fund manager will be responsible for formulating investment strategies for yielding the highest possible returns.

• Expense ratio

Investors must know details about the expense ratio of the fund. It is a maintenance fee that asset management companies (AMCs) charge their investors for funding the administrative and operating expenses of a scheme. The expense ratio of a fund highly influences what returns the investors can get from it.

• Exit load

Before making their investments, investors must take into consideration the exit load of a credit risk mutual fund. Investors must pay a penalty fee or an exit load for some mutual funds for withdrawing funds from the scheme before a certain period.

• Fund history

One should also evaluate the performance history of a fund. A mutual fund scheme with a record of consistently good performance is likely to deliver good returns. However, please note that past performances do not guarantee future returns..

• Portfolio diversification

Investors must build a diversified portfolio to minimise the risks of investments. They need to stay away from a concentrated portfolio. A heavily concentrated portfolio, which focuses on a few instruments or groups, may lead to high volatility in the portfolio. 

However, before investing, the investor must consider his financial goal, risk appetite, the fund manager’s expertise, past performance of the fund, expense ratio, and exit load. 

List of Top Credit Risk Mutual Funds in 2022 

The table below lists the best credit risk mutual funds in India in 2022 based on their five-year annualised returns: 

*Returns data valid as of August 19, 2022 

Final Word

Knowing what a credit risk mutual fund is, helps people make more informed decisions. Investors need to assess their risk appetite thoroughly before investing, as these schemes are ideal for investors with a high-risk appetite. To sum up, credit risk funds are debt schemes investing in low-rated corporate bonds and investors are rewarded with higher returns for the risk they take. The list of top credit risk funds has been provided above for readers’ benefit. 

Frequently Asked Questions