Credit risk funds are a class of debt funds that invest in bonds rated AA and below. Investing in these funds unleashes the potential to earn high returns. We have covered the following in this article on best credit risk funds:
As the name suggests, credit risk funds are those debt mutual funds that assume higher levels of credit risk by constituting a portfolio dominated by corporate bonds that are rated AA and below. It is for this reason that credit risk funds carry higher levels of credit risk than gilt and other safer classes of debt funds. Credit risk funds have the potential to provide higher returns than the debt funds that invest mostly in high-rated fixed-income securities. Credit risk funds have a track record of offering about 3% higher returns than other classes of debt funds. Investing in this fund is suitable for those willing to assume some amount of risk.
The following table shows the best-performing credit risk funds based on the past 3-year and 5-year returns:
Since credit risk funds carry a higher risk than most debt funds, it makes suitable only to aggressive investors. Also, investors should have some knowledge of how the markets play so that they can time their entry and exit accordingly. Even though the fund manager takes care of everything, it would be good to know the basics. Investing in this fund is suitable for those investors having an investment horizon of five years. If you have a shorter investment horizon, you may consider investing in liquid or overnight funds.
As credit risk funds are a class of debt funds, they are necessarily taxed like any other debt mutual funds. The dividends offered by these funds are added to your overall income and taxed as per the income tax slab rate you fall under. This is known as the classical way of taxing dividends and was introduced in the Budget 2020.
Short-term capital gains are those gains realised on selling your fund units within three years from the date of allocation. These gains are added to your overall income and taxed at the income tax slab rate you fall under. Long-term capital gains are realised on selling your units after a holding period of three years. These gains are taxed at a rate of 20% after indexation.
The most significant risk possessed by a credit risk fund is credit risk. This is the possibility of the issuers of the underlying securities, not making the coupon payments and returning the principal invested upon maturity. Since these funds invest in bonds rated AA and below, the credit risk is on the higher side. Other than credit risk, these funds carry liquidity risk and interest risk.
Liquidity risk is the possibility of the fund manager being in a position wherein he is not able to sell the underlying assets without taking a significant hit. Interest risk is the probability of the interest or coupon rate fluctuating due to the market and economic developments.
You need to understand the risk-reward ratio of credit risk funds before investing. Since these funds invest mostly in corporate bonds rated AA and below, they essentially carry higher risk. At the same time, the return potential is higher when compared to liquid and overnight funds.
You have to assess your risk profile and ensure that you have the appetite for assuming the levels of risk associated with credit risk funds before investing. It would be best if you have an investment horizon of at least five years. This gives the fund a much-needed time to mitigate associated risks.
The following are some of the most significant advantages of investing in credit risk funds: