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    Credit Risk Funds – Meaning, Features & How does it work?

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    What is a Credit Risk Fund? - Meaning & Features Of Risk Funds

    Mar 26, 2024
    5 min | Views 354

    Are you looking for fixed-income opportunities that offer potential higher returns while maintaining safety? Credit risk debt funds have emerged to address this market gap by investing in moderately riskier corporate bonds after thorough selection procedures.

    This article analyses the magnificence, benefits, investment frameworks, and performance measures of this growing mutual fund category to help investors make informed investment decisions.

    What Is Credit Risk Funds?

    Credit risk funds primarily invest in fixed-income instruments carrying relatively higher default risk in pursuit of elevated income gains. Corporate or high-yield bond funds allocate over 65% of assets towards papers rated AA and below rated corporate bonds (excluding AA+ rated corporate bonds) to generate additional yield.

    Fund managers utilise their in-house credit skills to manage default risks and keep them within acceptable limits. These funds are aimed at investors willing to tolerate occasional volatility in exchange for regular high payouts.

    Features of Credit Risk Funds

    Credit risk funds typically exhibit the following characteristics:

    • Expert fund management teams specialising in credit evaluation

    • Optimal liquidity management insulating portfolios from mass redemptions

    • Scope for capital appreciation if underlying bond ratings upgrade over time

    • Customisation across product variants to address varying needs

    How do Credit Risk Funds Work?

    Credit funds work through portfolio managers leveraging in-house credit analysis to determine issuer selection, entry/exit timing from papers and managing risk/return tradeoffs.

    Strict evaluation of factors like cash flows, promoter quality, macroeconomic factors, and business cycles facilitates the identification of pockets of value across lower-rated bonds where incremental yield over sovereign securities justifies the marginal lag in safety.

    Diversification across issuers and industries protects against concentration risks. The overall portfolio would reflect ratings dispersion across AA and below rated corporate bonds (excluding AA+ rated corporate bonds) in line with the mandated minimum 65% allocation stipulation applicable to this category.

    Fund managers stay vigilant about adverse rating actions towards downward drifts by timely shifting exposure to upgraded issuers, ensuring risk remains symmetric. The end goal is the optimisation of high-carry income at acceptable default risks.

    Should You Invest in Credit Risk Funds?

    Credit risk funds are best suited for informed investors with a higher risk tolerance and volatility in their fixed-income investments. These funds are not for the faint-hearted or conservative income investors.

    One should invest provided they possess the necessary ability, willingness, and investment horizon to stay invested through episodes of market uncertainty. A well-diversified portfolio at the investor level is imperative.

    Benefits and Drawbacks

    Some benefits and drawbacks associated with credit risk funds:

    Benefits

    • Potential for higher returns compared to traditional debt funds

    • Adds diversification within fixed-income asset class funds

    • Expert fund managers actively manage credit quality funds

    Drawbacks

    • Higher volatility compared to high-grade debt fundsfunds

    • Vulnerable to credit rating downgrades and defaults

    • Liquidity risk if excessive redemption pressures arise

    Factors To Consider Before Investing In Credit Risk Funds

    While evaluating funds in this category, some key risk factors need to be assessed:

    1. Credit Quality: Check underlying portfolio credit profile and rating distribution across instruments. Avoid undue issuer or sectoral concentration risks.

    2. Interest Rate Risk: Analyse portfolio duration based on the maturity profile of holdings and gauge sensitivity to rate changes.

    3. Liquidity Risk: Evaluate potential liquidity pressures during global risk-off episodes and redemption scenarios.

    4. Fund Manager Track Record: It is critical to have prudent managers with specialised credit skills and risk management expertise.

    Taxation Of Credit Risk Funds

    On the taxation front, credit risk schemes enjoy similar benefits as available to open-ended plain vanilla debt funds:

    • Short-Term Capital Gains (STCG): If the investment in credit risk funds is held for less than three years, the gains are considered short-term capital gains and are taxed as per the individual's income tax slab rate.

    • Long-Term Capital Gains (LTCG): If the investment is held for more than three years, the gains are considered long-term capital gains. For debt mutual funds, including credit risk funds, LTCG exceeding Rs. 1 lakh in a financial year is taxed at 20% with the benefit of indexation.

    • Dividend Distribution Tax (DDT): When credit risk funds declare dividends, they are subject to dividend distribution tax. As of the latest tax regime, dividends are now taxed in the hands of the recipient at their applicable income tax slab rate.

    Investors should consider their investment horizon and tax implications before investing in credit risk funds. It is advisable to consult with a tax advisor for personalized advice.

    Conclusion

    Credit risk funds allocate a portion of debt allocation to expertly managed portfolios of corporate bonds across the credit rating spectrum. These funds can be considered by investors willing to accept risks in exchange for a yield pick-up over traditional options.

    Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

     

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