Credit Risk Mutual Fund : Features, Suitability, Advantages & Disadvantages

What is Credit Risk Mutual Fund?

Credit Risk Mutual Fund is a kind of mutual fund that engages in generating higher returns by investing funds in lower-rated debt securities. Such securities pay out a higher yield than high-rated debt securities or government bonds which also carry lower risk. Credit Risk Mutual Funds are framed to cater to the needs of those investors who want to experience the mutual fund market and are beginners in the market. Some of the Credit risk mutual funds are ICICI Prudential Credit Risk Debt FundDirect Plan-Growth, HDFC Credit Risk Debt FundDirect Growth, and Kotak Credit Risk FundDirect Growth.

While investing in the mutual fund market, the invested capital is divided into equity, which includes investing in the stock market, and debt funds, which is also called fixed-income security and deals with bonds. Bonds are then given ratings by credit rating agencies like CRISIL, ICRA, etc. based on their credit quality the issuing company’s financial strength, and the ability to pay interest and repay the principal amount. These ratings are denoted as AAA, which is the highest rating that signifies best financial health, followed by AA, A, BBB, BB, B, and so on.

• Credit Risk Mutual Funds are those debt funds that mainly invest in bonds that possess an AA or lower rating.
• As per the guidelines by the Securities and Exchange Board of India (SEBI), Credit Risk Mutual Funds have to invest about 65% of the fund in lower than AA-rated bonds. Since these bonds do not have the financial strength of higher-rated bonds, their interest payments and principal repayment are not guaranteed and are doubtful. That’s the reason for the name Credit Risk Funds.

Features of Credit Risk Mutual Fund

1. Riskier: Credit Risk Mutual Funds are considered riskier investment schemes as they are those funds that invest in bonds that have AA or lower credit ratings, which signifies higher risk.

2. Diversification: Credit Risk Mutual Funds give you a mixed character for the portfolio. The portfolio comprises both bonds that invest in AA or lower rating bonds and 35% of proceeds are invested in different classes of assets, which helps the investor to diversify its portfolio.

3. Credit Risk: It is the risk that is associated with the borrower of the loan. It indicates the inability of the borrower to repay the debt/loan amount. In case the issuer of securities defaults, the mutual fund may not receive the due amount in full, this may reflect a negative result on the NAV of the scheme.

4. Volatility: Credit Risk Mutual funds temper the portfolio volatility as they adjust the price fluctuations.

5. Non-Biased: The Credit Risk Mutual Funds are non-biased as the decision of selection of low-rated securities is taken by the fund manager and the expertise of AMC, which leads to the selection of the best wealth-generating fund for the investor.

6. Less Liquid: Due to the lower credit quality of the underlying bonds of credit-risk debt funds, these bonds are not likely to be easily sold in the market. Therefore, credit risk funds may have liquidity limitations presented as compared to other debt funds, especially those that invest in high-credit-quality papers.

Purpose of Credit Risk Mutual Fund

1. To Attract High Returns: Credit Risk Mutual Funds are a source of stable and constant return-giving funds for their portfolio, they give better returns as compared to other equity-based funds. Credit Risk Mutual Funds have proved to give higher returns in medium and longer time duration.

2. To Diversify Portfolio: Credit Risk Mutual Fund invests in the ratio of 65:35 between debt-based securities and another asset category. This helps investors to diversify their portfolios among different classes of assets.

3. To Invest in a Fund with Debt Allocation: An investor who wants to minimise the volatility of equity-based funds looks to invest in the Credit Risk Mutual Fund, as it invests predominantly in debt-based securities.

4. To Gain Regular Income: Regular-income seeker investors always keep some portion of their portfolio in equity. Combining equity with high-return earning fixed-income instruments helps navigate income needs as well as helps beat inflation. Investors look for Credit Risk Mutual Funds as an option for regular income.

Who Should Invest in Credit Risk Mutual Fund?

1. Investors Seeking Better Returns from Fixed-Income Investments: A credit risk mutual fund can be a good choice for those investors if they aim to earn comparatively better returns than most fixed-income investment schemes.

2. Investors Having a Higher Risk Appetite: Credit risk mutual funds are relatively riskier and are volatile, the investor should invest in them only if they have the appetite to tolerate such high risk. In case an investor wants to invest in a low-risk and stable debt scheme, investing in a credit-risk fund is not prudent to invest.

3. Investors Having a Medium-Term Investment Horizon: If the investment horizon of an investor is up to 2 to 3 years, credit risk mutual funds can be a suitable option. However, this comes with the caveat that the investor has a higher risk tolerance.

4. Investors who look for Diversified Investment Option: Credit Risk Mutual Fund helps the investor to diversify their portfolio and add the feature of constant returns to their portfolio, as Credit Risk Mutual Fund help investor get return from both debt-based securities and other class of asset while staying invested in only one fund.

Factors to Consider Before Investing in Credit Risk Mutual Fund

1. Diversification: Credit Risk Mutual Funds are managed by fund managers, and every fund will have its own set of parameters and composition of different asset classes. So, the investor needs to study the individual composition that fits his investing parameter.

2. Time Horizon: If an investor has a medium to long time horizon, only then he/she should consider Credit Risk Mutual Fund, as they have proved to be beneficial in the long run, i.e. around a period of three years. If investors have short-term goals, and they are looking for a fund, Credit Risk Mutual Fund might not be the right choice for them.

3. Tax Implications: Investors need to ascertain the tax implication of the fund, if he/she is ignorant about the tax implication, they might not get a fruitful return out of it.

4. Risks: Investors should consider his/her risk appetite before investing. Credit Risk Mutual Funds are prone to risks and are categorised as high-risk funds on investment riskometers. If the investor wants to minimise the risk, he/she should approach a fund that has a lower dependence on equity.

5. Expense Ratio: Investors should precisely go through the investment terms and conditions, and should carefully understand the expense ratio, as a fund with a lower expense ratio is always better than a fund with a higher expense ratio.

Advantages of Credit Risk Mutual Fund

1. Better Returns: Credit risk mutual funds carry the potential to earn better returns as compared to other debt mutual funds investing in higher-rated bonds. These funds may also offer fairly regular and constant dividends when the fund’s underlying securities perform well. They carry the potential to help investors achieve their short or medium-term financial goals.

2. Diversification of Capital: As Credit risk Mutual Funds invest the capital in a ratio of 65:35 among the different asset classes, this gives exposure to different asset classes to the investor and balances the portfolio by investing in both low-rated securities and other asset classes.

3. Steady Returns: Credit Risk Mutual Fund, being diversified in nature has the main advantage of gaining returns even in volatile market conditions. Investors who have risk-bearing capability, prefer Credit Risk Mutual Fund for steady returns.

4. Flexibility: Credit Risk Mutual Funds have a high degree of flexibility associated with them, as at any time the fund can change its invested asset class within the 35% of the assets proceeds to manage his/her holding between the prevailing market condition if it is not favourable to the portfolio. Also, two different investment routes are available for investors i.e. SIP or lumpsum investment plan.

5. Expert Opinion: A Credit Risk Mutual Fund being managed by an experienced fund manager gives investors the best choice of asset class, Investors can avail the benefit of different classes of assets by selecting only one fund.

Disadvantages of Credit Risk Mutual Fund

1. High Risk: Credit Risk Mutual Funds possess a high degree of risk as they invest in low-rated securities and many times the ability of the companies to repay the dues is in question, which creates the risk of losing the capital.

2. No Guarantee of Success: The allocation of assets and selection of low-rated securities in a Credit risk mutual fund stands different between different fund managers or AMC, so the returns will also differ as per the allocation. The portfolio by nature gives the investor an element of discretionary exposure due to the ability that the fund manager possesses to change the mix of assets in the fund.

3. Higher Cost: Credit risk mutual funds charge much higher fees than traditional single-asset class funds as additional management is required to manage the portfolio across asset classes and a good amount is invested in the research of better low-rated securities.

4. Taxation on Short-Term Holding: If an investor holds a Credit risk mutual fund for a short-term duration, say 1 year, he/she shall be liable to pay tax as per their applicable income tax slab rates, and no benefit of indexation will be available.