What is a credit risk fund?

Credit risk funds hope to generate higher returns by taking higher credit risk by investing in lower rated papers

Kavya Balaji   /   October 8, 2020
What is a credit risk fund?

After the Yes Bank bond problems, investors are now wary of debt mutual funds, especially credit risk funds. Read about Yes Bank here – How the Yes bank fiasco will affect your mutual funds. Now, what are credit risk funds? Are they that risky? Letís understand.

What is a credit risk fund?

Credit risk funds are a category of debt mutual funds that have at least 65% of their investments in papers that are rated less than AA. They have the ability to generate higher returns by taking higher credit risk by investing in lower rated papers. Credit risk funds gained popularity among investors as they had the potential for double digit yields. How? By investing in lower rated securities, the mutual funds bet on the potential for credit rating upgrades for the papers. Also, credit risk funds could provide accrual income as they earn interest income from the coupon offered by the papers they hold in their portfolio. The papers offer greater interest rates and potential capital gains as and when their ratings move up. As of 2019, credit risk funds had Assets Under Management of over Rs. 67,000 crores.

Whatís in their portfolio?

Credit risk funds can hold 65-100% of their portfolio in papers that are rated less than AA and 0-35% in other investments. Unlike duration-based debt mutual funds, credit risk funds have accrual income and they donít bother much about interest rate movements. Also, the interest rate risks in these funds is lower because most of the funds are of a lower duration. Credit risk funds do not get impacted by macro events making them an all-weather mutual fund. Typically, these funds provide returns that are 2-3 % more than those of risk-free investments.

How do these funds work?

Credit risk funds receive interest income and since they have lower rated investments, they provide capital gains if the rating of the bond is upgraded.

How are credit risk funds taxed?

Dividends that you receive from credit risk funds were exempt from tax earlier and mutual funds paid the Dividend Distribution Tax (DDT) of 29.12% on the dividends declared by them. However, as per the proposals announced in the Union Budget 2020, dividends will be added to your income and taxed according to your income tax slab thatís applicable to you. This is with effect from April.

Returns that you earn from credit risk funds are subject to Short Term Capital Gains (STCG) tax if you sell the funds within three years of investment. This tax will be per your income tax bracket. If you have held the funds for more than three years, you get the advantage of indexation. You are eligible for Long Term Capital Gains (LTCG) tax at 20% with indexation.

Why are people wary of credit risk funds?

Debt funds have got attention because of the multiple credit defaults by debt issuing companies. There have been rating downgrades too over the past year. Credit risk funds have seen sharp fall in their Net Asset Values (NAV) as valuations of debt papers have come down.

Note that not all credit risk funds have fallen steeply. For instance, in the past three years, a few funds have given negative returns while some have returned 1-3% CAGR while more than 9 funds have given returns of 4-7% CAGR. Obviously, some funds have been able to rise above the problems. The main reason why these funds have done well is because they avoided concentrated exposure to a few credit securities.

Should you consider credit risk funds now?

Now, buying of credit risk funds have slowed down. However, some of the funds still have good valuations. If you didnít know, credit spread is the difference between the yield on a corporate bond and a government bond. The present credit spreads are attractive and they are above historical average. When credit spreads are above historical average, well-managed credit risk funds will deliver superior risk-adjusted returns. However, we would like investors to be aware of the risky nature of the fund as credit defaults could affect the net asset value. The defaults happen when there is corporate distress due to economic collapse. The Covod-19 related lockdown and the resultant economic impact has affected many corporates and that has in turn affected many debt funds, including credit risk funds.

Selecting a credit risk fund

If you are looking to invest in a credit risk fund, then you should look at large funds (larger assets under management). Funds that have more assets have the scope for diversifying and spreading risks. Thereís another reason why large funds are the better for investors. Credit-risk funds have higher liquidity risk. If the fund has a bond with a lower rating and that bond issuing company defaults or faces a further downgrade, it will be difficult for the fund manager to exit the holding. Thatís why investors need to choose large-sized funds in this category.

Diversified exposure

The most important point is to ensure that the fundís portfolio is not concentrated in any single business group. The fund shouldnít have high holdings in a single group. Adequate diversification within securities is a must. This means the fund should have a good number of different securities that help lower individual issuer/business group exposure. You should also look at a fund with a lower expense ratio as a standard filtering criterion.

Investment process

Try and choose a fund house with good experience in managing debt portfolios. A credit risk fund is only as good as its investment process. The fund houseís investment process should be clear and should have strong credit research skills. When choosing the fund, your order of priority should be safety, liquidity and returns. The fund house should have a proper risk control mechanism. Tools for liquidity management, duration management, concentration management and credit management are important.

Make sure that you donít hold more than 20% of your debt portfolios in such funds.

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