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What is a Credit Risk Fund

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05 Aug 2023

Introduction

Are you looking for a high-yield investment with the potential for big returns? If so, you may want to consider investing in a credit risk fund.

Credit risk funds are a type of mutual fund that invests in debt securities that are rated below investment grade. These securities typically offer higher yields than investment-grade securities, but they also carry more risk.

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Let's discuss what credit risk funds are, how they work, and the factors you should consider before investing in one.

What are credit risk funds?

Credit risk funds invest in debt securities that are considered being of low quality, i.e., credit rating below AA. These funds invest at least 65% of their money in low-rated companies. Borrowers with lower credit ratings are considered being riskier, so they have to pay more interest to lenders to compensate for the increased risk of default.

Credit risk funds are one of the riskiest in the category, despite lending mostly for a short duration. Fund managers balance the risk and enhance net asset value (NAV) by choosing other highly ranked securities along with credit risk funds.

Features of credit risk funds

Some of the salient features of credit risk funds are mentioned below:

  • Tax efficient: Credit Risk Funds are tax-efficient for high-tax-bracket (30%) investors, as long-term capital gains (LTCG) from these funds is taxed at 20% only.
  • High return, high risk: Credit risk funds invest in low-rated debt assets, offering higher interest rates to compensate for the risk. They can provide attractive returns but carry liquidity risk compared to other debt funds.
  • Importance of Fund Manager: The fund manager selects low-rated securities to invest in, which affects the fund’s performance.

How do credit risk funds work?

Credit risk funds invest in lower-rated bonds, offering higher interest rates to compensate for the extra risk. When these bonds improve in rating, capital gains can be significant, leading to higher returns. The fund manager maintains control over credit quality and default probability. Returns are typically 2-3% higher than risk-free debt investments.

What are the factors to consider before investing in credit risk funds?

When considering credit risk investments, it's best to opt for a credit risk mutual fund rather than creating your own portfolio. Look for funds with a large corpus for better diversification and reduced risks. Check the expense ratio and research the fund manager's experience. Choose a fund that is diversified across various securities. Typically, investors allocate 10-20% of their portfolio to credit risk funds.

Conclusion

Credit risk funds offer higher returns but come with higher risks. If you're willing to take on the risks for potential profits, be certain to undertake thorough research before investing in these funds.

 

Related Blogs: What is a Holding Period | Mutual Funds for Students: Building Wealth for Tomorrow | Mutual Fund V/s Fixed Deposit | How Often Should You Review Your Mutual Funds Investment

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