In general, “credit risk” refers to the risk of losing the invested money due to a default in payment by the borrower. It is an inherent risk associated with lending money and investing in securities with low credit rating.
Credit risk funds are high-risk instruments that invest in securities with lower creditworthiness (less than AA-rated) with an aim to generate high returns.
In this blog, we will look at what are credit risk funds, how do they work, if there’s an incentive to invest in these funds, and what factors should be considered before such investments.
Important: This blog is meant to educate readers and the information furnished here is not to be construed as investment advice from Cube Wealth.
What Is A Credit Risk Mutual Fund?
A credit risk fund is a type of debt mutual fund that invests a major portion (at least 65% as per SEBI guidelines) of its fund in low-rated securities.
The risk of investing in such a mutual fund is very high. That is the reason credit risk funds conduct an in-depth analysis of various securities before investing.
The objective of a credit risk fund, like all mutual funds, is to maximize returns for its investors. To achieve this, they charge a higher interest rate to borrowers through the securities they invest in.
Borrowers agree to pay a higher interest rate in order to compensate for the lower credit rating. The credit risk fund’s investment in the securities may help improve the Net Asset Value of the fund and give the securities a chance to improve their performance.
Credit risk funds generate returns in two ways:
- In the form of interest earned on the investment
- In the form of capital gains, in case the credit rating of the security improves
5 Key Features Of Credit Risk Mutual Funds
If you are considering investing in credit risk mutual funds, here are some important features that you should keep in mind:
1. High Risk
Investing in low rated securities comes with the apparent risk of default. In case the borrower is unable to pay out the interest amount, it further downgrades the rating of the security. Inability to pay back the principal investment results in complete investment loss for the fund.
2. Higher Interest Income
Investing in low-rated securities is a risky business. Therefore, credit risk funds charge them a premium rate of interest. This premium results in a potentially higher interest income as compared to investments in high-rated securities.
3. Higher Capital Gains
Investments allow low-rated securities to improve their performance and move up to better credit rating. Improvement in rating also pulls up the overall valuation of the security, implying higher capital gains for the risk fund.
4. Liquidity Concerns
Low-rated securities pose serious liquidity concerns in case of defaults. It further downgrades the value of the security and it becomes difficult to sell or redeem it.
5. Tax Benefits
Short Term Capital Gains (STCG) are taxed according to the investor’s I-T bracket. Long Term Capital Gains (LTCG) are taxed at 20% along with indexation benefits.
Thus, credit risk funds may be tax-efficient for long-term investors, who fall in the highest tax slab (30%). However, ELSS funds offer better tax benefits (up to Rs. 1,50,000) than credit risk funds.
Read this blog to learn more about tax saving mistakes to avoid in 2021
How Do Credit Risk Mutual Funds Work?
The portfolio of credit risk funds is divided between debt securities and other market-related financial instruments. The commonality between these two kinds of investments is that the instruments have a low credit rating and offer a higher interest rate.
With such a portfolio, credit risk funds—on an average—have been known to offer 2-3% higher returns than risk-free debt investments. Also, while investing, the fund manager tries to choose securities that have a lower default probability.
However, this may seem contradictory to the fund’s underlying nature which is why investors may find it more efficient to invest in other mutual funds like:
1. Liquid funds
2. Overnight funds
3. Ultra short term funds
4. Banking and PSU funds
5. Large-cap equity funds
Should You Invest In Credit Risk Mutual Funds?
Credit risk funds may be suitable for investors with a high-risk appetite. As compared to other debt schemes, they have a much higher risk factor and therefore may not suit conservative investors.
Fund managers try to minimize the risk by choosing securities carefully. However, the risk of default or a downgrade in rating still exists. This can be a risky situation.
Therefore, you must speak to a Cube Wealth Coach to know if you should invest in credit risk funds. Alternatively, you can download the Cube Wealth app to get curated mutual funds based on your risk profile and investment goals.
5 Factors To Consider Before Investing In Credit Risk Mutual Funds
#1 Size of the Fund
Funds with a large corpus are in a better position to spread out their risk. It helps them mitigate risk by diversifying across securities with varying credit ratings and interest rates.
#2 Portfolio Diversification
Financial advisors often recommend choosing a credit risk fund that is diversified across various securities. The portfolio of the fund should not be concentrated on any particular sector or business group.
However, it would be better for investors to speak to a Cube Wealth Coach to understand the investment and find out if credit risk funds are suitable for their portfolio.
#3 Expense Ratio
The expense ratio of a fund is indicative of its ability to manage its expenses. It can hugely impact a fund’s net profitability. Moreover, funds that charge a higher expense ratio may eat away at the profits.
Therefore, it is important to evaluate the expense ratio of every mutual fund that you invest in. Read this blog to understand mutual fund jargon in-depth.
#4 Reputation of the Fund Manager
When it comes to credit risk funds, the experience and expertise of the fund manager become extremely important. The manager must have dealt with credit risk funds in the past and should have a good track record.
#5 Ratio of Credit Risk Investment in a Portfolio
Consulting a wealth coach is important when investing in a high-risk instrument like credit risk funds. Usually, such investments should be limited to 10-20% of the overall portfolio.
