The open-ended debt schemes which invest in below highest rated corporate bonds are called Credit Risk Mutual Funds. In this article, you will read about what are credit risk funds, their advantages, how credit risk funds work and more-
Table of Content:
What Are Credit Risk Funds?
Mutual funds investing in low rated securities, offering potential for investors to earn good returns are called credit risk funds. These are categorised under debt funds wherein minimum 65% of the portfolio is invested in less than AA-rated papers. Basically, the credit risk funds are popular for generating higher returns by indulging into higher credit risks through investment in low rated papers.
When the performance of the company improves, the bond ratings issued by the company also upgrades. In that case, relatively higher interest rates are provided to the investors of credit risk funds. Also, as compared to other risk-free debt funds, credit-risk funds have the ability to offer 2-3% higher returns.
The Working of Credit Risk Funds
Credit risk funds typically obtain returns in two ways:
- By earning interest income on the securities held by these funds
- Capital Gains originated as a corollary to investments made in low-rated securities which tend to upgrade eventually. On comparing with liquid or overnight funds, it has been recorded that Credit risk funds typically gives 2% higher returns.
Advantages
Check out what good you can extract from a portfolio with Credit Risk Funds-
- Higher Returns
Such funds take high credit risks and invest in low rated papers which, when their rating improves, offer capital gains and higher interest rates. Consequently, the returns generated are higher as compared to other fund types
- Tax Benefits
The dividends are exempt from taxes. However, the scheme is required to pay 28.84% DDT (Dividend Distribution Tax). Returns earned over a period of 3 years of investment are subject to Short Term Capital Gains Tax (STCG) as per the income tax slab. Especially for investors in the highest tax slabs, Credit Risk funds are tax-efficient as the Long Term Capital Gains (LTCG) is only 20% while their tax slab rate is 30%
- Extended Supervision
In the case of Credit Risk Mutual Funds, fund managers play a very significant role in obtaining remarkable returns. An analytic and extensive approach is employed by the management to pick the best low rated securities. With this approach, Credit rating of a company is not the only factor which is considered while picking the stocks. Parameters such as the company’s scope of expansion, its potential to grow and business model hold equal value
Who should invest in Credit Risk Funds?
- At times, low-rated papers also face downturns against expectations. As a result, these funds are known for having higher risks as compared to other debt schemes. Implying that investors with high risk tolerance can opt to invest in such funds
- Investors in the highest tax slab seeking tax saving investments can choose to invest in these funds
Things to be considered while investing in Credit Risk funds
As the name Credit-risk funds suggests, there is a high risk of liquidity involved in such funds. There are chances that the fund might downgrade. Consequently, investors with higher appetite for risk in fixed income can invest in these funds.
- For instance, if a bond which has a lower rating in the portfolio fails to show improvement and defaults, the fund manager faces great difficulty while exiting the holding. Fixating the same, financial planners advise the ones investing in such mutual funds to look up to large-sized funds.
- Choosing funds with higher assets renders the fund manager with a better canvas to diversify the portfolio and spread risk accordingly.
- The manager of the fund must also make sure that the portfolio is not highly concentrated.
- Any single business group must not be having high possessions, in the portfolio.
- The qualitative factors such as experience of the fund manager and fund house plays a vital role. Investors must choose the fund managers who have sufficient experience in handling debt portfolios.
- Because there is much risk involved, investors should not hold more than 20% of their debt portfolio in such mutual funds.
Taxation Policy for Credit Risk Funds
The schemes under Credit Risk Fund is obliged to pay 28.84% Dividend Distribution Tax. However, Dividends are not taxable at the hands of the investor. Moreover, the returns earned from these Mutual Funds types/schemes within a period of 3-years from investment are subject to STCG Tax (short-term capital gains tax) which is calculated according to the investor’s income tax slab rate. After the completion of this 3-year period, investors become eligible for 20% LTCG Tax (Long term capital gains tax) with indexation benefit.
Best Credit Risk Funds
Here is a list of top 10 credit risk mutual funds which can be considered under investment options-
| Fund Name | AUM (Cr) | 1-Year | 3-Year | 5-Year |
| HDFC Credit Risk Debt Fund – Direct Plan | 14,886.68 | 9% | 8% | 9% |
| ICICI Prudential Credit Risk Fund – Direct Plan | 10,792.61 | 9% | 8% | 9% |
| Reliance Credit Risk – Direct Plan | 7,478.44 | 4% | 7% | 8% |
| Franklin India Credit Risk Fund – Direct | 6,866.74 | 7% | 8% | 9% |
| Aditya Birla Sun Life Credit Risk Fund – Direct Plan | 6,244.19 | 7% | 8% | – |
| SBI Credit Risk Fund – Direct Plan | 5,244.54 | 7% | 8% | 9% |
| Kotak Credit Risk Fund – Direct Plan | 4,745.36 | 9% | 8% | 10% |
| UTI Credit Risk Fund – Direct Plan | 3,799.58 | 3% | 6% | 8% |
| DSP Credit Risk Fund – Direct Plan | 2,748.11 | -4% | 3% | 6% |
| L&T Credit Risk Fund – Direct Plan | 2,682.24 | 5% | 7% | 8% |
How to Invest?
There are different methods through which one can invest in small cap stocks:
- Offline mode– Visiting the nearest branch office of the fund house and investing in the desired scheme. You must carry all the required documents such as Identity Proof, Address Proof, Cancelled Cheque, Passport size photos, PAN Card and KYC Documents handy. You can also invest offline through a broker. However, this would then be a regular fund and not a direct fund. Think of it like a charge brokerage which gets deducted from the total investment amount
- Online Portal– If you want a hassle free mode of investing with no commissions and brokerage, you can choose websites like Paisabazaar.com which allow the investors to compare more than 1,700 funds at one platform instead of visiting the website of each AMC and then searching for numerous funds. You can select the fund in which you want to invest, look at the details and compare similar schemes as well as use SIP Calculator or Lumpsum Calculator to estimate the future value of your investment
FAQs on Credit Risk Funds
Q. What is the definition of Credit Risk Funds as per SEBI?
Ans. The Securities and Exchange Board of India has defined Credit Risk Funds as a category of debt funds which invest a minimum of 65% of the investment portfolio in debt papers that have been rated AA and below.
Q. Does low credit rating of an instrument imply high risk on investment, if one chooses to invest in that instrument?
Ans. Credit rating of an instrument reflects the ability of the issuer to honour its debt obligations (interest plus principal) at maturity. However, it should be noted that credit rating is done at the time of issuance of a security. It doesn’t tell us about what happens at maturity. Many times, instruments with high credit rating are not able to payback interest and principal to lenders, because of business losses and the related reasons. This implies that credit rating is not the only factor to quantify risk. There can always be exceptions.
Q. How are credit risk funds different from duration funds?
Ans. Credit risk funds bet on debt securities with low credit rating but high return potential, whereas duration funds generate returns through management of interest rate risk on the underlying instruments. The latter bets on the interest rate movements and capturing the best of it to appreciate investors’ capital.
Q. Is the investment philosophy of all credit risk funds alike?
Ans. No. Some mutual fund schemes believe in “Return of principal is more important than return on principal” , while others believe in betting on loss of principle in the hope of high returns.
Q. What kind of credit risk fund portfolio should an investor opt for?
Ans. In the credit risk category, investors should look for a diversified portfolio, as opposed to a concentrated one. A portfolio which is heavily concentrated in few instruments or groups can lead to high volatility in the portfolio.
Q. Is a credit risk fund very risky?
Ans. Yes. These funds do carry credit risk. However, the risk-returns reward is high. With high risk, investors have an opportunity to earn high returns, provided they stay invested for a long period of time, and can withstand volatility in Net Asset Value of the fund.