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Credit risk funds – What are they, Working, Advantages, Taxation

  • Finity Research
  • Jan 12 2022
  • 8 minutes
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Mutual funds have proved that they can deliver strong results if the investor stays invested for a considerable period of time. These funds provide many opportunities for the investors to invest in various asset classes where investment in individual assets is not only expensive but risky too. While for traditionally risk-averse investors, mutual funds are only viewed as a pool of top-class equities or debt instruments, there are various categories of funds that invest in riskier assets and are targeted by aggressive investors having a high-risk appetite.

Credit risk funds are one such class of mutual funds that are considered riskier for risk-averse investors but can provide high returns at a considerably higher risk. Given below are the details of these funds.

What are credit risk funds?

Credit risk funds are a type of debt mutual funds that invest in low-rated fixed income securities of the corporate sector. These instruments carry a higher credit risk as compared to top-rated debt instruments and hence also offer interest at a higher rate. Credit risk is the risk taken by the investors with respect to any default of payments due made by the issuer of the debt instrument. 

Top-rated debt instruments refer to the rating of AAA which is the highest credit rating issued by certified agencies. Credit risk funds invest in corporate securities that have ratings of AA or lower and offer a higher rate of interest to compensate for such high risk. The risk of default on such securities is higher. Credit risk funds are a pool of such high-risk instruments providing them an opportunity to perform better than other debt instruments.

How do credit risk funds work?

As per SEBI guidelines, these funds are required to invest a minimum of 65% of their fund in corporate debt securities having a rating of AA+ or lower. When the rating of the underlying securities is upgraded, the fund is benefitted from such improved ratings. It results in higher capital gains for the investors. 

When the borrower defaults in payments towards any underlying security, its credit rating is affected or downgraded. This results in loss or reduced capital gains for the investors. The other source of income for these funds is the interest payments made by the borrower. The fund manager has to ensure that the overall rating of the credit risk fund is maintained. An average credit risk fund should be able to generate at least 2-3% higher returns than risk-free debt funds.

What are the advantages of credit risk funds?

Investment in credit risk funds has certain inherent advantages for the investors, some of such advantages are discussed below.

1. Increased returns

Credit risk funds provide higher returns to the investors as compared to other debt funds. As the risk of investment in these funds is high, this risk is compensated through a higher coupon rate. It allows the investors to meet their medium-term to long-term financial goals and a chance to earn regular income.

2. Expertise of fund managers

The expertise of the fund managers is crucial for the performance of these funds. Investors get the benefit of skilled fund managers that have a good knowledge of the markets to ensure that they are able to generate higher returns than risk-free debt funds. 

What are the disadvantages of credit risk funds?

After discussing the advantages of these funds, let us now consider their disadvantages.

1. Higher risk

The risk of default of principal or interest is high in these funds. Also, there is a high chance of the underlying securities being downgraded resulting in a loss for the investors. 

2. Lower liquidity

Liquidity is another issue that affects these funds. If the assets of the fund are downgraded it becomes difficult to liquidate them. India is facing major credit issues on account of a series of defaults in 2018 by IL&FS group or other corporates like Vodafone, DHFL. This has resulted in reduced investor confidence leading to higher redemption which becomes difficult to meet by these funds. 

3. Not suitable for risk averse investors

Credit risk funds belong to a high-risk high return category. These funds are not suitable for all types of investors. Investors who have a stomach for high risks can invest in these funds as the risk of default is quite high. Traditional and risk-averse investors are advised to stay away from these funds.

Who should invest in credit risk funds?

Credit risk funds have the fundamental feature of being high-risk funds even though they belong to the debt mutual funds category. These funds are not suitable for weak-hearted investors or investors looking for steady income. Investors that belong to a high-income tax bracket and have a high-risk appetite are best suited for such funds.

What are the points to be considered before investing in credit risk funds?

Investors have to consider certain basic factors before making an investment decision in the credit risk funds. Some of such factors are highlighted below.

  • Investors should be aware of the risks associated with an investment in these funds. They should be aware of their exposure.
  • Fund houses having a higher volume of Assets under management are able to spread their risks better. This is another factor to be considered while making an investment decision. Investors have to consider a fund that has higher Assets under management to reduce their risk profile and get a chance to earn higher returns.
  • Fund managers are highly critical to the credit risk funds. It is therefore essential to invest in funds that have highly experienced and qualified fund managers. 
  • Credit risk funds should not exceed more than 20-30% of the investment portfolio. This ensures that the risk of the investor is limited and they are not overexposed which may lead to a drastic reduction in their returns. 

How are credit risk funds taxed?

Credit risk funds being part of the debt mutual funds category are taxed in a similar manner. These funds are liable to capital gains depending on the period of holding. The short-term capital gains on funds held for less than 3 years are taxed as per the applicable slab rates of the investors. On the other hand, long-term capital gains are taxed at the rate of 20% along with the benefit of indexation. The taxation of these funds is simplified in the table given below.

Type of fundsShort term gainsTax rateLong term gainsTax rate
Credit risk fundsLess than 36 monthsSlab rate of investor36 months and more20% (plus cess and surcharge)

Investors belonging to the highest tax bracket thus have an advantage of reducing their tax liability by being invested in these funds for the long term. 

Top credit risk funds

HDFC Credit Risk Debt Fund 

This fund was launched in 2014 and has been providing good returns to investors since its launch. Some of the details of the fund are mentioned below.

ParticularsDetails
Fund managerMr. Shobhit Mehrotra
Launch date25th March 2014
Minimum investmentRs. 5,000
Expense ratio1.58%
RiskHigh risk

The returns provided by the fund as of 6th June 2021 are tabled below

Period6 months1 yr3 yrs5 yrsSince launch
Returns4.06%12.36%9.12%8.35%9.01%

Kotak Credit Risk 

This fund was launched by the fund house of Kotak Mahindra Mutual funds in 2010 and has been providing good returns to investors since its launch. Some of the details of the fund are mentioned below.

ParticularsDetails
Fund managerMr. Deepak Agrawal
Launch date11th May 2010
Minimum investmentRs. 5,000
Expense ratio1.69%
RiskHigh risk

The returns provided by the fund as of 6th June 2021 are tabled below

Period6 months1 yr3 yrs5 yrsSince launch
Returns3.01%8.75%7.40%7.46%8.11%
  • IDFC Credit Risk Fund

This fund was launched by the fund house of IDFC Mutual funds in 2017 and has been providing decent returns to investors since its launch. Some of the details of the fund are mentioned below.

ParticularsDetails
Fund managerMr. Arvind Subramanian
Launch date3rd March 2017
Minimum investmentRs. 5,000
Expense ratio1.61%
RiskModerately High risk

The returns provided by the fund as of 6th June 2021 are tabled below

Period6 months1 yr3 yrs5 yrsSince launch
Returns2.10%7.21%7.32%6.73%
  • Axis Credit Risk Fund

This fund was launched by the fund house of Axis Mutual funds in 2014 and has been providing decent returns to investors since its launch. Some of the details of the fund are mentioned below.

ParticularsDetails
Fund managerMr. Devang Shah
Launch date15th July 2014
Minimum investmentRs. 5,000
Expense ratio1.66%
RiskModerately High risk

The returns provided by the fund as of 6th June 2021 are tabled below

Period6 months1 yr3 yrs5 yrsSince launch
Returns3.48%8.83%6.66%6.74%7.58%

Conclusion

Credit risk funds are an excellent investment option for investors with a high-risk appetite and who belong to a high tax bracket. They can reduce their long-term income tax on capital gains by 10%. These funds, although riskier, have the potential to provide higher returns for the investors. But the risk associated with them is quite high. Investors have to thoroughly analyze their risk-return potential before making an investment decision.

FAQs

1. What is the mandatory investment requirement for credit risk funds?
A. Credit risk funds are required to have a mandatory investment of 65% of the fund in AA or lower-rated securities.

2. What happens when the underlying security has defaulted in the payment of principal or interest to the investors?
A. In case of a default in payment of interest or principal to the investors, the asset is downgraded by the credit rating agencies and this will impact its liquidity in the credit risk fund. 

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