Understanding Credit Risk Mutual Funds

July 13, 2022

Understanding Credit Risk Mutual Funds

Credit risk is one of the primary risks of investing in debt funds. It is the risk of default of the issuer of the security in repaying the principal amount or interest. Credit risk is higher with low-quality securities and therefore most conservative investors prefer mutual funds which invest only in high-credit quality debt securities. However, there is a type of debt fund which invests in low-credit quality securities. Let us understand about credit risk mutual funds in detail and know everything about it before investing in them.

·        What are credit risk mutual funds?

Credit risk mutual fund is a debt-oriented mutual fund that invests in lower rated debt instruments with the intention of maximization of returns. They aim to generate higher returns by investing in securities that pay a higher yield than high rated funds. On the other hand, high rated corporate or government securities carry a lower risk. Credit risk funds require a stable or favorable credit environment to outperform the other debt funds. SEBI has issued guidelines which require that a mutual fund must invest at least 65% of its corpus into debt instruments, having a rating below AA+ to qualify as a credit risk mutual fund.

The bond ratings improve when the performance of the company increases. In such a scenario, the investors receive higher interest rate. Also, when compared to other risk-free debt funds, these funds can generate higher returns.

·        How to invest in credit risk mutual funds?

Credit risk is associated with borrowers defaulting payments to the lenders. Credit risk funds invest more than 65% of their assets in securities where default risk is high. They invest in securities rated AA and below. However, to compensate for the risk taken, the coupon rates on these securities tend to be high. Thus, making the credit risk fund’s returns higher than other funds.

Credit risk funds have a higher risk as compared to other debt schemes. While the fund manager anticipates an upgrade in the credit rating of an underlying security, there is a possibility of a further downgrade of a low-rated instrument. This can have a huge impact on the performance of the fund. Hence, you must consider investing in these funds if you have a medium-to-high risk tolerance and want to invest in debt funds.

You need to understand the risk-reward ratio of credit risk funds before investing. Since these funds invest mostly in corporate bonds rated AA and below, they essentially carry higher risk. At the same time, the return potential is higher when compared to liquid and overnight funds.

·        Where to invest?

A credit risk mutual fund is a debt-oriented mutual fund that invests in lower rated debt instruments with the intention of maximization of returns. Let's see two major investment options that help investors invest in credit risk funds.

1.      For debt allocation

Those investors who are risk-averse with their fixed-income allocation and have a very low tolerance for any negative experience in this segment should stay away from credit-risk funds. For them, versatile categories, like short-duration funds, are a more viable option. Such funds have the flexibility to invest across different kinds of debt securities and they do not take much credit risk by investing heavily in lower-rated bonds.

2.      For regular-income seekers

As we always say, even regular-income seekers should keep some portion of their portfolio in equity. Combining equity with high-quality fixed-income instruments helps navigate income needs as well as beat inflation. Investors can either set their asset allocation themselves or choose to invest in hybrid funds such as conservative hybrid and equity-savings funds.

·        Conclusion

Credit risk mutual funds thus although classified as a debt mutual fund, has different characteristics than typical debt funds. They are a good opportunity in a stable economy wherein the economy is growing and companies are flourishing. In such circumstances, investors can enjoy the high returns of these funds. In a volatile economy however, where the outlook for growth is negative, credit risk funds are risky and their performance suffers.

Investing in credit risk funds is not an easy decision. There are a lot of risks such as interest rate risk and payment default along with other factors that need to be considered before investing.




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