What are Credit Risk Funds?
All debt funds come with the risk that the issuer of debt securities will default in the repayment of principal or interest. The risk is magnified for investors who invest in low-rated securities. View More
However, risk and return have an inverse relationship- the higher the risk, the higher the return. So while conservative investors look for risk-free options, some seasoned investors are willing to increase their risk appetite for higher returns.
Credit risk funds provide an avenue for such investors. These special category debt funds invest 65% of their corpus in low-rated securities (AA rated or below). The aim is to generate 2-3% extra returns by taking higher credit risk.
Who Should Invest in Credit Risk Funds?
Credit Risk Funds are short-term investments that can generate the highest returns among debt funds. The typical tenure of these funds is 3 to 5 years. However, these funds carry significant risk and are only suitable for investors with a high-risk appetite. Risk-averse investors looking for regular income best avoid this fund. View More
Having said that, even risk-tolerant investors should be prudent while investing in Credit Risk Funds. Here are a few factors one should consider to increase their credit risk fund returns.
- Be aware of the risk level associated with the credit risk mutual fund.
- Look for funds with larger AUM (Asset under Management). A larger corpus allows for more diversification and spread of the credit risk.
- Check the total expense ratio (TER) before investing in credit risk funds. A lower TER gives a higher return to the investor.
- Look for funds that do not have a highly concentrated portfolio. Ensure that a single business group is not dominating the portfolio. Diversification across various businesses and securities helps reduce the credit risk.
- The fate of credit risk funds largely depends on the estimate of portfolio managers. Choose managers who have good experience in handling such portfolios.
- Properly plan your investment in high-risk funds. Most investors refrain from investing more than 20% of their portfolio in credit risk securities. A measured call is necessary while investing in high-risk securities.
The above considerations will help you select the best credit risk funds to add to your portfolio.
Features of Credit Risk Fund
Credit risk mutual funds are special debt funds with unique features. Below are some distinct features of the fund.
Credit Risk Premium
Credit risk funds provide credit premiums to investors directly proportional to the credit risk associated with the investment. The credit risk premium (or credit spread) increases with the decrease in credit risk. View More
Potential for Capital Appreciation
Credit risk funds invest in bonds that are not the highest rated. Therefore, the portfolio provides space and potential for rating upgrades, leading to capital appreciation.
Credit risk funds invest in fixed income securities that provide pre-determined interests to investors on a periodical basis. The accrual interest gets factored into the market price of these securities. This increases the valuation of the securities, directly benefiting the investors.
Not suited For All
Credit risk funds are high on default and liquidity risk. They are not meant for risk-averse investors or investors looking for stable income.
Taxability of Credit Risk Funds
Credit risk funds are taxed like any other debt fund securities. Dividends paid by the funds were previously exempt in the hands of investors. But the 2020 Budget changed the system of mutual funds paying dividend distribution tax. View More
As a result, the investors will have to pay tax on dividends as per their slab rates.
The capital appreciation on credit risk funds are taxed as capital gains in the following manner:
- Fund units sold within three years- Short Term Capital Gains taxed at their regular slab rates
- For units held for three or more years – Long-term capital gains at the rate of 20% with indexation.
Indexation allows investors to adjust their investment costs with the inflation rate. It reduces their gains for tax computation, bringing down the effective tax rate to even lower than 20%.
Hence, the best credit risk funds also provide considerable tax advantage along with high returns.
Risk Involved With Credit Risk Funds
Risk is part and parcel of credit risk funds. The funds can be highly volatile and thus need a solid risk management strategy. Some of the risks associated with credit risk funds are as follows:
Since credit risk funds deliberately invest in low-rated securities, the default risk is naturally higher than other debt securities. View More
If the borrower defaults in principal or interest payment, the security gets downgraded. This can negatively impact the performance of the fund. Most fund managers manage the credit risk by making informed investment decisions after thorough research and analysis.
Credit risk funds are also tight on liquidity. So in case of a downgrade, managers may have a hard time exiting the holding. That’s why investors are advised to choose large corpus funds in this category.
Concentration risk pertains to the risk of high exposure to a single business group. Funds mitigate this risk by diversifying their portfolio across sectors and setting an internal limit for exposure to a single business group.
Credit risk funds are also subjected to interest risk like other debt funds. Rising interest rates may reduce the bond price, making the fund less attractive over time.
Advantage of Credit Risk Mutual Funds
Avenue for Risk Exposure
Investors can expose a portion of their portfolio to high-risk debt securities through credit risk funds and earn better yields. In addition, they can leverage the expertise of skilled fund managers to meet their mid to long-term financial goals. View More
Once the securities get upgraded, the capital gains earned on credit risk funds can be very high. As a result, they provide returns higher than most classes of debt funds. The difference can be as high as 3%. These funds can also offer regular dividends and stable earnings if the underlying securities perform well.
Credit risk funds offer long-term capital gain tax benefits for investors holding funds longer than three years. The capital gains are taxed at a 20% rate instead of the regular slab rates. It is especially beneficial to investors at the highest tax bracket of 30% since they get a concession of 10% from their typical slab rates.