Credit Risk Fund

Credit risk funds are mutual funds investing predominantly in lower-rated company debt securities, thereby undertaking higher risk due to the increased default likelihood. These funds seek higher returns by directing at least 65% of their assets towards these lower-rated companies.

Content:

• What Is Credit Risk Mutual Fund?
• Credit Risk Fund – Features
• Credit Risk Fund Taxation
• Credit Risk Funds Returns
• Are Credit Risk Funds Safe
• How Do Credit Risk Mutual Funds Work?
• Credit Risk Funds In India
• Credit Risk Fund – Quick Summary
• Credit Risk Fund – Frequently Asked Questions

What Is Credit Risk Debt Mutual Fund?

Credit risk funds are a type of debt fund that allocates a minimum of 65% of its assets to companies with relatively lower credit ratings. Due to their lower creditworthiness, these companies offer higher interest rates to offset the increased risk of default. This elevated default risk poses a greater level of uncertainty for the lenders.

These funds aim to generate higher returns by taking on the risk of lending to companies with a higher probability of defaulting on their payments. Investors in credit risk mutual funds are compensated for this increased risk through the higher interest rates offered by these companies.

Credit Risk Fund –  Features

The main feature of credit risk funds is that they are tax efficient. Investing in these funds benefits those with the highest tax slab because the tax levied for LTCG is 20%. 

Other features of credit risk funds are given below: 

• Higher Returns

 Credit risk funds invest in low-rated debt assets, which are riskier. To make up for this risk, these funds pay a higher interest rate called a premium coupon rate. These funds can provide greater returns, making them appealing to investors seeking better-than-average investment returns.

• Liquidity Risk

Credit Risk Funds are subject to liquidity risk, which refers to the difficulty of recovering an investment without suffering a loss in its value. The liquidity risk is higher in Credit Risk Funds compared to other debt funds. Investors may need help finding buyers for their funds, resulting in potential liquidity issues.

• Tax efficient

The Credit Risk Funds are tax-efficient investment choices, especially for people that come under higher tax bracket. The LTCG received from these funds is taxed at just 20%.

Credit Risk Fund Taxation

Credit risk funds are taxed based on the holding period. Funds held under three years face taxation as per the investor’s income bracket (short-term gains). Conversely, investments exceeding three years (long-term gains) incur a 20% tax post-indexation benefits. 

• Short-term Capital Gains: If a credit risk fund investment is held for less than three years, any gains from selling the fund units are considered STCG. The short-term capital gains are taxed according to the investor’s applicable income tax slab rates. 

• Long-term Capital Gains: If a credit risk fund investment is held for over three years, any gains from selling the fund units are classified as LTCG. For debt funds, including credit risk funds, long-term capital gains are taxed at a flat rate of 20% (plus applicable cess and surcharge) after indexation benefit.

Credit Risk Funds Returns

Credit risk funds can potentially deliver higher returns than other debt funds. Credit risk funds have delivered an average annualized return of 7.78% over the past year. The 3-year and 5-year annualized returns are 7.63% and 5.94%, respectively. 

Are Credit Risk Funds Safe

Credit risk funds offer investors higher returns than other types of debt funds. These funds aim to compensate for the increased risk associated with their investments by providing a higher coupon rate. This enables investors to pursue their medium to long-term financial objectives while also having the opportunity to earn a consistent income stream.

Moreover, credit risk funds may face liquidity challenges, especially during periods of market stress or when there is a lack of buyers for the lower-rated securities held by the fund. This can make it difficult for investors to redeem their investments when desired. Also, the credit risk fund’s performance is influenced by factors such as changes in interest rates, credit ratings, and overall market conditions.

How Do Credit Risk Mutual Funds Work?

Credit risk funds are mutual funds primarily investing in corporate debt securities with lower credit ratings. These funds seek to achieve higher returns by targeting securities rated below AA+ that offer a higher yield than those that invest in higher-rated instruments. 

The primary sources of returns for credit risk mutual funds are interest income and capital gains. Investors earn interest from the coupon payments made by the fund’s underlying securities. The lower credit rating of these securities generally results in higher coupon rates, which translates into higher interest income for investors.

Also, credit risk funds may generate capital gains when the credit rating of lower-rated security held in the portfolio improves. As the security’s creditworthiness improves, its market value increases, leading to capital gains for the fund. This can enhance the overall performance and returns of the fund. However, investing in credit-risk mutual funds carries inherent risks. There is a higher likelihood of default by borrowers associated with lower-rated securities. In the event of a default, the security may be downgraded, impacting the fund’s capital gains potential. 

Credit Risk Funds In India

The list of credit risk funds in India is given below: 

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Credit Risk Fund – Quick Summary

• A credit risk fund is a mutual fund that primarily invests in debt securities issued by companies with lower credit ratings. 
• Credit risk funds are a type of debt fund that allocates a minimum of 65% of its assets to companies with relatively lower credit ratings. 
• The main feature of credit risk funds is that they are tax efficient. Investing in these funds benefits those with the highest tax slab because the tax levied for LTCG is 20%. 
• Credit risk funds have delivered an average annualized return of 7.78% over the past year. The 3-year and 5-year annualized returns are 7.63% and 5.94%, respectively. 
• Credit risk funds may face liquidity challenges, especially during periods of market stress or when there is a lack of buyers for the lower-rated securities held by the fund. 
• Some credit risk funds in India are DSP Credit Risk Direct Plan-Growth, UTI Credit Risk Fund Direct-Growth, Kotak Credit Risk Fund Direct-Growth, and HDFC Credit Risk Debt Fund Direct-Growth. 
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Credit Risk Fund – Frequently Asked Questions

1. What is a credit risk fund?

Credit risk funds are a type of debt fund that allocates a minimum of 65% of their funds to companies with lower credit ratings. Due to their lower creditworthiness, these companies are charged higher interest rates to offset the increased risk of default.

2. What is an example of credit risk?

A company may default on various types of loans or financial obligations. A company may face difficulties repaying debt secured by assets, such as fixed or floating charge debt. Additionally, non-payment can occur when a business fails to settle a trade invoice.

3. Is it safe to invest in credit risk fund?

Credit risk funds allocate a significant portion, exceeding 65%, of their assets to securities with a higher likelihood of default. These funds specifically target securities with credit ratings of AA and below.

4. Is it good time to invest in credit risk fund?

Although it is a  good time to invest in a credit risk fund but as an investor, you should check the expense ratio of the fund, along with the background of the fund manager before investing in any credit risk fund.  

5. How is credit risk fund taxed?

Credit risk funds are taxed as short-term capital gains if held for up to three years, while they are taxed as long-term capital gains for more than three years. The tax rate for short-term gains is determined based on the investor’s income tax slab. On the other hand, long-term gains from debt funds, including credit risk funds, are taxed at a rate of 20%.