Credit Risk Mutual Funds – Concept, Objective, Strategy, Features, Evaluation & more
In this article we will look at what Credit Risk Mutual Funds are, what is its investing strategy as well as it return potential and risk susceptibility.
Debt mutual funds typically have three types of risks – interest risk, credit risk and liquidity risk.
Credit risk is a risk of default – risk that the issuers of the debt securities will not pay the interest dues or may not repay part or whole of the principal.
While fund managers typically would look to reduce the credit risk by investing in high quality debt securities, there are certain types of funds that take on credit risk.
These are Credit Risk Funds.
About Credit Risk Mutual Funds
Credit risk mutual fund is a debt-oriented mutual fund that invests in lower rated debt instruments with the intention of maximization of returns.
As the name suggests, fund managers of credit risk funds look to earn higher returns at the cost of taking on additional credit risks.
SEBI has issued guidelines which require that a mutual fund must invest at least 65% of its corpus into debt instruments which have a rating below AA+ to qualify as a credit risk mutual fund.
The main objective of credit risk fund is to earn higher returns for its investors in the following ways:
- Investing in lower rated debt securities which carry higher coupon rate hence will give higher returns
- Investing in debt securities whose ratings are expected to increase which will have a positive impact on the net asset value (NAV) of the fund, earning capital gains
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Investing strategy of Credit Risk Mutual Funds
In India, there are certain accredited agencies that assess the credit worthiness of corporates and other bond issuing entities.
Based on their assessment of the issuer’s credit worthiness they issue a credit rating to its debt securities. The highest credit rating is AAA and progresses to AA, A, BBB, BB and so on till D.
These agencies regularly monitor the activities of the companies as well as the changes in macro-economic factors and assess their impact on the credit worthiness.
The issued ratings can be upgraded or downgraded by the agency as and when warranted. These agencies include CRISIL, CARE, ICRA etc.
Typically, debt securities that have a lower credit rating (below AA) are riskier. To compensate for this additional risk, these securities bear a higher coupon rate.
Fund managers of credit risk mutual funds invest in these lower rated bonds with the intention of earning higher returns.
Fund managers undertake a detailed study and analysis of each of these entities and choose those who they believe will not default on payment of their obligations.
They also seek out debt securities which although currently low rated, have the potential for a rating upgrade in the near future. This will push the NAV of the fund upwards.
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Features of Credit Risk Funds
Here are the list of Top Features of Credit Risk Funds –
Higher credit risk
These mutual funds are susceptible to a high level of default risk. Debt securities have a low credit rating owing to some factors which indicate a likelihood of default on the part of the issuer.
By investing in such debt securities, the mutual fund takes on a high level of credit risk.
This is especially true in unstable economic times when the risk of corporate collapses is higher.
For example, the current global COVID pandemic has seen closure or failure of several companies. Many of these companies have defaulted on their debt obligations.
Several credit risk funds have suffered great losses owing to this. This makes credit risk mutual funds highly risky in volatile times.
Higher return potential
The return potential from these mutual funds is twofold. One is a higher coupon rate that is attached to lower rated debt securities.
Second is the potential for capital gain that can be earned when the rating of debt securities are upgraded.
The fund invests in debt securities that already have low credit rating. Any further downgrade in their rating will make them very unattractive to investors.
This makes their trade limited and it becomes very difficult for fund managers to liquidate them. Even if liquidated, it is likely to be at heavy losses for the fund.
These mutual funds have the same taxability as any other debt mutual funds. Their gains are taxed as capital gains on redemption.
Short term if held for less than 3 years and long term if held for more than 3 years.
Short term funds are being taxed at the investor applicable slab rate and long term being taxed at a beneficial rate of 20% post indexation benefit.
Who should Invest in Credit Risk Mutual Funds?
These mutual funds are quite different from other debt-oriented mutual funds. This makes these funds amenable to specific type of investors and investing situations:
- It is suitable for aggressive investors with high-risk appetite. This is due to the high credit risk and liquidity risk that these funds are subject to.
- There is a chance that investors may actually lose out on part of their capital, if there are any defaults. This makes it suitable for only high-risk investors who can afford to take on such level of risk.
- Investing in credit risk funds is more suitable during stable economic times when companies are expected to perform consistently.
- A highly volatile economic environment puts pressure on corporates and will only compound the risk level of these funds.
- These funds are not suitable for funding critical goals of investors. As there is a risk of capital loss, it is best that investors apply these funds for less critical goals or to their surplus funds.
- Investors can invest surplus funds in these funds with the objective of earning extra return.
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Evaluation of Credit Risk Mutual Funds
Before deciding to invest in credit risk mutual funds, investors should keep certain key factors in mind:
The high-risk levels that these funds are subject to should be kept in mind. Investors who are not comfortable with such high levels of risk should stay away from such funds.
Look for diversified funds
The credit risk reduces by investing across a diverse portfolio of bonds. This will cushion the fund from any default by a single debt security.
A portfolio that is concentrated in limited debt securities has a higher risk. This is because any default will have a huge negative impact on valuation of the fund.
Assess size of the fund
The value of the fund assets under management (AUM) determines the size of the fund. The higher the AUM, the higher is the scope for diversification.
Thus, a larger fund house with higher AUM in its credit risk funds can diversify their credit risk better.
Assess fund manager expertise
The success or failure of this fund is highly dependent on its fund manager’s ability.
Fund managers must have the experience of dealing in debt securities as well as the foresight to be able to predict which way the companies’ performance will move.
A good fund manager can choose good debt securities whereas a poor fund manager may select wrong debt securities further accentuating the risk level.
Investors must seek out funds that have expert and experienced fund managers.
Evaluate market situation
Investors should gauge the market situation and opt for credit risk mutual funds if they foresee a stable market scenario.
Like all other mutual funds, this fund also charge an annual fee for managing the fund. This is expressed as a % of its AUM and called expense ratio.
A higher expense ratio goes to reduce the investor’s return from the fund. Investors should opt for funds that have a lower expense ratio.
Benefits of investing in Credit Risk Funds
Here are the advantages of investing in Credit Risk Mutual Funds –
This funds have the advantage of earning higher returns than other categories of debt mutual funds.
They earn from higher coupon rates as well as have the opportunity to earn capital gains.
Tax efficient for high tax slab investors
High income investors are taxed at the maximum slab rate which is 30%. The income in the form of capital gains earned from these funds is taxed at a beneficial rate of 20% (in case of long-term holding).
Thus, investment in these mutual funds are tax efficient for high income investors who are otherwise taxed at 30%.
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Drawbacks of Investing in Credit Risk Mutual Funds
Here are the few major disadvantages of Credit Risk Funds –
High risk of default
The high credit risk that these funds take on means that they are susceptible to a high risk of default.
When debt securities held by the fund default, investors can lose out not only on interest but also on their principal invested.
Liquidity issues for the fund manager
The low rating and high risk of the comprised debt securities make them relatively illiquid. These securities do not trade in very large volumes on the market.
This makes it difficult for fund managers to actively manage the portfolio by switching in and out of debt securities holdings.
Not suitable for typical debt fund investors
The mainstay of debt oriented mutual funds is that they have low risk as compared to market linked equity funds. They thus find takers in conservative investors.
These funds are however completely opposite as they are subject to high risks. Thus, these funds are not suitable for conservative investors who generally opt for debt mutual funds.
Credit Risk Mutual Funds – Conclusion
Credit risk mutual funds thus although classified as a debt mutual fund, has different characteristics than typical debt funds.
They are a good opportunity in a stable economy wherein the economy is growing and companies are flourishing.
In such circumstances, investors can enjoy the high returns of these funds.
In a volatile economy however, where the outlook for growth is negative, credit risk funds are risky and their performance suffers.
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