Credit Risk Funds: Features and Investment Considerations

When you invest in Debt Funds, the fund issuer borrows money from you. Your principal investment remains locked, and you only receive it on maturity. You earn rewarding interest rates through the investment term. Have you ever wondered what happens if the issuer fails to repay the principal or interest? It is declared a default payment and can cost you terribly. Credit risk rating defines the credibility of the issuer.

A higher credit rating translates to lesser chances of default. This allows you to be worry-free about your Mutual Fund Investment. However, several investors invest in low-rating Debt Securities. The fund that invests in low-rating securities are called Credit Risk Funds. Here is what you should know.

Why do fund managers invest in it?

Given their low rating, Credit Risk Funds offer a higher interest rate. Fund managers invest in low-rating securities hoping their credit rating improves. Meanwhile, the higher interest rates boost the fund’s Net Asset Value. When the credit rating of the securities improves, the fund benefits. However, the Credit Risk Fund entirely depends on assumptions. Instead of the credit rating getting better, it can deteriorate.

In such a case, your investment bears a heavy loss. Hence, you should observe caution when investing. Generally, the Credit Risk Fund offers an interest rate 2-3% higher than risk-free Debt security. Almost all securities below ‘AA’ rating are classified as Credit Risk Funds. Choose a fund wisely that offers moderate risk and fair returns. An added advantage here is tax efficiency.

Returns from Debt instruments are Long-Term Capital Gains. You can claim a tax indexation of 20% on your investment returns.

What are the factors to consider?

Risk appetite: Credit Risk Funds involve a high degree of risk. There is liquidity and concertation of investment risk. Hence, you should invest in them only if you have a medium to high-risk appetite. The higher interest rate offering can be very tempting. But you should not be swayed away and be mindful of your risk appetite.

Fund manager: Your fund manager plays an essential role in your Mutual Fund Investment. They decide your asset allocation. It depends on their analysis to invest in such funds. Consider the experience of your fund manager before investing. Check how fruitful their previous Credit Risk Fund Investments turned out to be.

Diversification: Invest in these funds for a larger corpus. The fund should invest across various securities. This way, you can diversify your investment and minimize the risk associated.

Fund allocation: Usually, most fund managers limit such investment to 10-20% of your total portfolio value. Avoid going overboard with your Credit Risk Fund Investment.