What is a Credit Risk Fund in Indian Mutual Funds

A credit risk fund is a type of debt mutual fund that primarily invests in bonds or debt instruments issued by companies with lower credit ratings. The goal of these funds is to earn higher returns by taking on a higher risk compared to other debt funds. In India, credit risk funds allocate at least 65% of their assets to securities rated AA or lower. These funds are ideal for investors seeking higher yields from debt investments but are also willing to accept the increased risk of potential default by the issuing companies.

Key Features of Credit Risk Funds:

Higher Returns: These funds have the potential to offer higher returns than other debt funds due to the risk involved with investing in lower-rated securities.
Risk of Default: The primary risk is credit risk, which is the chance that the bond issuer may default on interest or principal payments.
Interest Rate Sensitivity: Credit risk funds are affected by changes in interest rates, though less so than gilt or government bond funds.
Suitable for Risk-Tolerant Investors: These funds are suitable for investors with a moderate to high-risk appetite looking for higher returns within the debt fund category.

How Do Credit Risk Funds Work?

Credit risk funds invest in corporate bonds and debt instruments issued by companies with lower credit ratings. These companies are typically rated AA or below by credit rating agencies. Due to the higher perceived risk, these companies offer higher interest rates on their debt instruments. By investing in such securities, credit risk funds aim to capture higher returns.

However, there is a trade-off: these companies are more likely to face financial challenges, making them more susceptible to defaulting on their debt obligations. Therefore, fund managers need to actively monitor the creditworthiness of the issuers and adjust the portfolio accordingly to mitigate risks.

Key Terms:

Credit Rating: A score given by rating agencies like CRISIL, ICRA, or CARE that evaluates a company’s ability to repay its debt. Lower-rated companies are considered riskier.
Yield to Maturity (YTM): The total return expected on a bond if held until maturity.
Credit Spread: The difference in yield between a corporate bond and a government bond of similar maturity. Higher spreads indicate higher risk.

Historical Performance of Credit Risk Funds

To better understand the potential returns of credit risk funds, let’s examine the historical performance of these funds compared to other types of debt funds.

Year	Credit Risk Fund Average Return (%)	Corporate Bond Fund Return (%)	Government Bond Fund Return (%)
2018	4.56%	8.24%	6.45%
2019	9.32%	11.28%	10.12%
2020	6.45%	10.84%	7.34%
2021	4.85%	5.32%	6.74%
2022 YTD	5.45%	7.89%	5.87%

As shown in the table, credit risk funds tend to provide higher returns than government bond funds but are more volatile compared to corporate bond funds. However, investors must be mindful of credit events (e.g., defaults or downgrades) that can significantly impact fund performance.

Risks Involved in Credit Risk Funds

While credit risk funds offer the potential for higher returns, they also come with several risks:

1. Credit Risk:

The primary risk in these funds is the possibility of the bond issuer defaulting on its interest or principal payments. This risk is higher in credit risk funds due to their focus on lower-rated securities.

2. Interest Rate Risk:

Like all debt funds, credit risk funds are affected by changes in interest rates. However, they are less sensitive to interest rate movements compared to government securities or gilt funds. When interest rates rise, the prices of bonds in the portfolio tend to fall, which could reduce the fund’s net asset value (NAV).

3. Liquidity Risk:

Some lower-rated bonds might not have a liquid secondary market, which could make it difficult for fund managers to sell these bonds when needed. This can affect the fund’s ability to meet redemption requests.

4. Concentration Risk:

If the credit risk fund has significant exposure to a few issuers or sectors, the performance of those issuers or sectors could heavily influence the overall performance of the fund. Fund managers must diversify adequately to avoid concentration risk.

Who Should Invest in Credit Risk Funds?

Credit risk funds are suitable for investors who:

Have a moderate to high-risk tolerance.
Seek higher returns from their debt investments compared to traditional fixed deposits or government bonds.
Are comfortable with potential fluctuations in the fund’s NAV due to changes in interest rates and credit events.
Have an investment horizon of at least 3 to 5 years, which gives enough time to ride out short-term market fluctuations.

These funds are not suitable for conservative investors or those looking for a stable and guaranteed income stream.

Comparison of Credit Risk Funds with Other Debt Funds

To understand the unique positioning of credit risk funds, let’s compare them with other popular types of debt funds:

Fund Type	Risk Level	Expected Return	Credit Rating of Securities	Ideal Investment Horizon
Credit Risk Fund	High	High	AA and below	3 to 5 years
Corporate Bond Fund	Moderate	Moderate	AA+ and above	2 to 4 years
Government Bond Fund	Low	Low	AAA (Sovereign)	1 to 3 years
Liquid Fund	Very Low	Low	AAA (Short-term securities)	Less than 1 year

As shown, credit risk funds offer the highest potential returns but come with higher risks compared to other debt funds like government or corporate bond funds. Liquid funds, on the other hand, offer low risk but correspondingly lower returns.

Historical Credit Events and Impact on Credit Risk Funds

Credit risk funds in India have experienced several credit events in recent years that impacted their performance. One such event was the default of IL&FS (Infrastructure Leasing & Financial Services) in 2018, which caused a significant decline in the NAV of many credit risk funds. Similarly, the downgrade of DHFL (Dewan Housing Finance Corporation Limited) in 2019 affected several credit risk funds that had exposure to DHFL’s debt.

These credit events highlight the importance of fund manager expertise in selecting quality debt instruments, even when they are lower-rated. Fund managers who can assess credit risk effectively and diversify their portfolios can mitigate the impact of such events.

How to Select the Right Credit Risk Fund

Selecting the right credit risk fund involves assessing several key factors:

1. Credit Quality:

Look for funds with a diversified portfolio of bonds from issuers across various sectors. Funds with concentrated exposure to specific companies or sectors carry a higher level of risk.

2. Fund Manager’s Track Record:

Evaluate the track record of the fund manager in managing credit risk and navigating challenging market conditions. A seasoned fund manager can make informed decisions to minimize risks while capturing higher returns.

3. Expense Ratio:

Credit risk funds often come with higher management fees compared to other debt funds. It’s important to consider the expense ratio as higher fees can erode your returns over time.

4. Performance Consistency:

Look for funds that have delivered consistent returns over different market cycles. While past performance does not guarantee future returns, it provides insights into how the fund performs in various conditions.

5. Risk-Adjusted Returns:

Evaluate the fund’s risk-adjusted return, which takes into account the level of risk the fund assumes to generate returns. A fund with a higher Sharpe ratio indicates better risk-adjusted performance.

Taxation on Credit Risk Funds

The taxation of credit risk funds in India depends on the holding period:

Short-Term Capital Gains (STCG): If the investment is held for less than 3 years, the gains are taxed as per the investor’s income tax slab.
Long-Term Capital Gains (LTCG): If the investment is held for more than 3 years, the gains are taxed at 20% with indexation benefits. Indexation adjusts the purchase price of the units to account for inflation, thereby reducing the taxable gains.

This tax treatment makes credit risk funds more favorable for long-term investors who can take advantage of the indexation benefit.

Conclusion: Should You Invest in Credit Risk Funds?

Credit risk funds can be an excellent investment option for those seeking higher returns from their debt portfolio and who are willing to take on additional risk. These funds can serve as a valuable diversification tool for investors with a moderate to high-risk appetite.

However, it’s essential to be aware of the risks involved, particularly the credit risk associated with lower-rated bonds. If you are willing to invest for the medium to long term and are comfortable with potential fluctuations in the fund’s value, credit risk funds could be a suitable addition to your portfolio.

Always consult with a financial advisor before making investment decisions, especially in funds that involve credit risk.