Credit Risk Funds: Features & How to Invest

Most of us are aware of the different types of equity funds. Large cap funds, small cap funds and mid-cap funds are some popular categories of equity funds. However, many individuals are not aware of the different categories of debt funds.

Market regulator, Securities and Exchange Board of India (SEBI) has divided debt funds into several categories. One category that has been in news since September 2018 is credit risk funds. The problems in the category started with the IL&FS group defaults. The recent episode is the closure of a few Franklin Templeton debt funds.

Many investors are not aware how debt funds especially credit risk funds work. In this article, we will explain everything that you need to know about credit risk funds.

What are credit risk funds?

Debt funds invest in various investment options such as government bonds, corporate bonds and commercial papers. Corporate bonds are bonds issued for a period greater than 1 year by corporates to raise capital. Just like credit score such as CIBIL score shows the creditworthiness of individuals, credit rating agencies rate the papers issued by the companies. Based on the company’s ability to pay interest and principal, rating agencies assign rates such as AAA, AA to their papers. AAA-rated corporate bonds are the safest investment options. AA is the grade below AAA.

According to the SEBI’s definition, credit risk funds are open-ended debt schemes investing in below the highest-rated corporate bonds. And credit risk funds invest approximately 65% of its assets in papers rated AA.

How does a credit risk fund work?

As these funds invest in AA bonds, the bonds may fetch higher returns than the highest-rated papers. Moreover, when the ratings of these bonds move up, it also leads to capital gains. As a result, it may lead to higher returns for investors. These funds have lower risk to interest rate fluctuations. Typically, these funds give 2-3% higher returns than risk-free investment options.

Who can invest in credit risk fund?

As credit risk funds carry higher risk compared to other debt funds, investors should be careful before investing in these funds. Individual investors with a small portfolio can ignore this category of funds.

Investors with an investment horizon of around three years can invest in these funds.
Individuals who fall on the highest tax slab can invest in these funds to earn tax-efficient returns.

How to select a credit risk fund?

Credit risk funds are prone to defaults and downgrades that can lead to capital erosion. Hence, selecting the right credit risk fund is of prime importance.

To minimise the impact of downgrades on the fund’s returns, it is best to select large fund with a higher asset under management(AUM). The larger AUM offers greater diversification among different bonds, which lowers the risk associated with the fund.
Check the portfolio of the fund. Stay away from funds that are highly concentrated in a particular bond or bonds issued by a group company.
Select a fund from a well-established fund house with an experienced fund manager with an excellent track record.

Taxation of credit funds

The taxes on capital gains of credit funds are like debt funds. Tax on capital gains depends on the holding period. Short-term capital gains apply on the units of the mutual fund redeemed before three years from investment. Similarly, long-term taxation applies for units that stayed invested for over three years. Tax on the short-term capital gains is added to the investor’s income and taxed as per the relevant tax bracket. However, in case of long-term capital gains, the gains are taxed 20% with indexation benefits.

Things to consider before investing in Credit-risk Funds

As credit risk funds can go through sharp movements in their value, it may not be a good source of income.

Choose a diversified credit risk fund that invests across various securities.
Typically, one should not invest over 10-20% of their portfolio in credit risk funds.
Talk to your financial advisor or mutual fund distributor before investing in these funds.

Conclusion

As credit risk funds invest in corporate bonds rated AA or below, carries higher risk than other debt funds such as liquid funds or short-term funds. This additional risk may aid in giving returns to the investors. Credit risk funds can be a suitable investment option for investors in the highest tax bracket, with an investment horizon of about three years, who want higher returns along with tax efficiency. You can consult your financial advisor to know more.