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When it comes to investing in debt securities, one of the risks linked with them is credit risk. Credit risk is the risk associated with borrowing when the borrower fails to repay the lent money. It would also mean that the borrower has defaulted in repaying the principal and /or the interest at the stipulated time.
When it comes to investing in securities, low-quality securities have higher credit risk. This is the reason why investors, conservative or otherwise, sometimes choose to invest in high-credit debt securities like Mutual Funds.
When it comes to returns on investments, credit risk is rewarded with higher cash flows. This means that if there is a bond with high credit risk, the investor will be compensated with lucrative returns.
There is, however, a class of Debt Funds that are known to invest in low-credit quality securities. These are called Credit Risk Funds.
What is Credit Risk Funds meaning and should you consider them as a tool for investment?
What is a Credit Risk Fund
Also classified as a type of Mutual Fund, Credit Risk Funds invest in corporate debt securities which have been low-rated and are known to have low credit quality. As the name suggests, Credit Risk Funds are known to be high-risk investments, as they invest in low-rated instruments, usually AA rated or below.
The question that arises is why should you invest in a fund that has low credit ratings? Since Credit Risk Funds are securities with low credit ratings, they aim to offer a high rate of returns. How can you identify a Credit Risk Fund?
Individual investors can assess the risk by understanding the credit ratings as investigated by various credit rating agencies. If you want to invest in a high credit quality bond, you should look for AA and above ratings. These bonds have minimal risk of default. Any rating below BBB is considered to be high risk.
These ratings are not set in stone and can improve when the fund does well. When this happens, investors can receive superior interest rates. When you compare Credit Risk Funds to other risk-free Debt Funds, they are known to generate better returns as well.
According to SEBI’s guidelines, at least 65% of Credit Risk Funds need to be invested in papers having ratings below AA. These funds also need to have a stable credit environment and outclass other Debt Funds.
Features of Credit Risk Mutual Funds
Before you invest in Credit Risk Mutual Funds, here are some of the features that you should know about:
- Tax-Efficiency: When Credit Risk Mutual Funds are held for less than 36 months, the returns or profits on them attract short-term capital gain tax which are taxed as per the investors income tax slab. However, when they are held for 36 months or more the profits earned attract long-term capital gain tax of 20%, with the benefits of indexation, there are chances that you may end up paying less or sometimes NIL taxes on the profits.
- Higher Returns: Credit Risk Funds invest in low-rated securities. As compared to high-rated securities, the risk involved in these funds is higher. Due to this, they have a premium coupon rate, to compensate investors for the risk.
- Liquidity Risk: Liquidity risk is associated with most investments. When an investor has difficulty redeeming an investment without incurring a loss in the value of the security or instrument is defined as liquidity risk.
The occurrence of liquidity risk is also higher when the seller is unable to find a buyer for the funds. When it comes to the Credit Risk Fund, the liquidity risk is higher.
Who Should Invest In Credit Risk Funds
Most debt securities have a certain level of credit risk attached to them. Being low-rated securities, Credit Risk Mutual Funds come with an inherent default risk. The level of risk is higher as compared to other debt securities. So is it a good plan to invest in them?
Though the level of risk is high, Credit Risk Funds can anticipate an upgrade. This means that the credit ratings can see a jump when the fund’s performance is boosted. This is translated to an increase in earnings in terms of interest payments for the investor.
However, if the company is downgraded, credit ratings can also take a tumble. This situation may arise for non-payment of principal or interest repayments.
This is what makes Credit Risk Funds volatile. Credit Risk Funds can be one of the investment options if you have a mid to high-risk tolerance level.
Before investing, analyze the historical data of the fund you think you would want to invest in. An investor will also need to consider how the fund has performed during the changes in the macroeconomic factors.
These funds are suitable for investors who are willing to take high risk within the debt instruments category of investments.
Factors to Consider Before Investing In Credit Risk Mutual Funds
If you are considering investing in Credit Risk Mutual Funds, you should do your due diligence. There are a few things you should consider before investing:
- Check your Plan: Your investments need to align with your goals. Before investing in Credit Risk Mutual Funds, you should ensure that your goals and investment plan connect. If you wish to fulfill a short-term goal and plan to invest in a Credit Risk Fund, the possibility of completion of the same would be less.
- Percentage of Investment: There is a possibility that Credit Risk Funds can help generate better returns. This does not mean that you invest all your eggs in one basket. You can choose to invest about 10%-20% of your total portfolio in Credit Risk Funds.
- Large Corpus: While choosing to invest in Credit Risk Funds, look for funds or assets under management that have a large corpus of investment. This gives you an option to invest in various instruments and may help in lowering the risk associated.
- Expense Ratio: The annual maintenance charge levied by Mutual Funds to finance and manage their expenses is defined as the expense ratio. While investing in Credit Risk Mutual Funds, check what is the expense ratio, which should generally be low.
- Exit Load: The exit load will depend on the date of redemption. Funds are known to charge about 1% of units excess of 10% is redeemed or switched out within 1 year from the date of entry. However, exit loads vary from scheme to scheme.
Frequently Asked Questions (FAQs)
1. How does a Credit Risk Fund work?
Credit Risk Funds come with high default risk attached to them. However, these Credit Risk Mutual Funds can aim to generate returns in two ways:
1. Interest Income: Interests earned on the funds generate income for investors as these funds have a high coupon rate.
2. Capital gain: Credit Risk Funds invest in low-rated securities. Though they have a considerably high risk attached, once upgraded, these funds can earn capital gain on them.
2. Why should you invest in a Credit Risk Fund?
Before investing, you should check for the risk attached to the funds. Credit Risk Funds are high in risks. Investors who have medium to high-risk appetites can choose to invest in Credit Risk Funds.
3. Does Credit Risk Fund have an exit load?
Almost all funds have an exit load. Exit load is charged depending on the date of allotment and exit date. Funds are known to charge 1% if more than 10% of units are redeemed or switched out within 365 days, however, this varies from scheme to scheme.
4. Can we invest SIP in a Credit Risk Fund?
Depending on the fund, there are options available to invest in SIP or a lump sum amount.
5. What is the Lock-in Period for Credit Risk Fund?
There isn’t a lock-in period as such attached to Credit Risk Funds. However, if the returns are enjoyed before the completion of 36 months, they attract short-term capital gain tax. If it completes 36 months or is held for a longer period, it will attract long-term capital gain tax. Also, the exit load will depend on the date of redemption.
