What is Credit-Risk Fund?
Investors must remember that these funds frequently rise and fall
These days Credit-risk funds investing in low-rated securities are attracting investors due to their potential for double-digit yields. This article will explore the Credit Risk Funds for a better understanding of investors.
What is Credit-Risk Fund?
As per SEBI, credit risk funds are those open-ended debt schemes that invest in bonds that are below the highest-rated corporate bonds. These invest at least 65% of their money in less than AA-rated paper. These schemes may generate high returns from high coupon rates as compensation for taking higher credit risk. Thus returns from the credit risk fund are higher than other funds. However, the chances of downgrades and defaults in these papers are also there.
How are these funds going to work?
Credit-risk funds earn in two ways:
Interest Income: First, they receive interest income on the securities held.
Capital gains: Second, they can create capital gains if the rating of a security is upgraded.
The borrowers who are not-so-highly rated companies pay higher interest charges to compensate for their lower credit rating and offer a capital gain advantage as and when their ratings move up. The fund managers of these funds also choose securities that might get a boost in rating according to their analysis and, therefore, positively impact the NAV of the fund.
Who should invest in the Credit risk fund?
Credit risk funds are ideal for an investment horizon of at least 3-5 years. These come with reasonable risks like higher liquidity risk. Investors must remember that these funds frequently rise and fall; thus, they have a high probability of incurring a loss in the short term. Therefore, investors looking for a steady income and having the desire to minimize the risk factor should not invest in the credit-risk funds. Considering the above, if you have a high-risk tolerance, go for it.
Essential Features of Credit Risk Funds
Usually, these funds come with a premium coupon rate to compensate for the greater credit risk taken and return 2-3 percent more than risk-free investments. They tend to deliver higher returns than Bank Fixed Deposits.
These funds are very volatile. The credit risk funds are exposed to higher risk due to an increased possibility of default. Although the risk of interest in these funds is small because most of them are of a lower duration, still they are riskier. These funds also have more liquidity risks.
If the investment made in papers downgraded, it will be difficult for investors to redeem their papers.
People whose earning falls in the highest tax slab can also choose to invest in credit-risk funds to save on taxes. Returns within three years of investment are subject to short-term capital gains tax as per your income tax slab. After that tenure, they have to pay just 20% tax on long-term capital gains instead of 30%.
Things You Should Know before Investing in Credit Risk Funds
It is advisable to invest via a credit risk mutual fund but consider the following.
- Look for credit risk funds with bigger AUM having a better probability of diversifying the portfolio to spread the risk.
- Select a fund that have a low expense ratio.
- Research on the fund manager and look for one with good experience in handling debt portfolios.
- Choose a credit risk fund diversified across various securities that reduce the risks.
- Don’t invest more than 10-20% of the portfolio in a credit risk fund and, of course, check your investment plan before investing.
Current Scenario of Credit Risk Funds in India
The credit risk funds in India have taken a hit since September 2018. India has gone into a debt crisis with defaults from multiple big companies such as the IL&FS group, Vodafone Idea and DHFL default in the recent economic slowdown. Additionally, the Covid-19 pandemic has made the situation even worse. With the credit rating being downgraded, many of these funds failed to meet investors’ redemptions because of these low rated papers’ poor liquidity. The assets under management have reduced from INR 80,000 crores to INR 55,000.
To conclude, do not make any credit-risk fund-related investment decisions yourself, especially in more massive amounts, unless you are market-savvy. Take help from your financial advisor before you make these calls.
That’s why Comparte Investment team asks do you have “Nivesh Ki Aadat”.