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In general, “credit risk” refers to the risk of losing the invested money due to a default in payment by the borrower. It is an inherent risk associated with lending money and investing in securities with low credit rating.
Credit risk funds are high-risk instruments that invest in securities with lower creditworthiness (less than AA-rated) with an aim to generate high returns.
In this blog, we will look at what are credit risk funds, how do they work, if there’s an incentive to invest in these funds, and what factors should be considered before such investments.
Important: This blog is meant to educate readers and the information furnished here is not to be construed as investment advice from Cube Wealth.
A credit risk fund is a type of debt mutual fund that invests a major portion (at least 65% as per SEBI guidelines) of its fund in low-rated securities.
The risk of investing in such a mutual fund is very high. That is the reason credit risk funds conduct an in-depth analysis of various securities before investing.
The objective of a credit risk fund, like all mutual funds, is to maximize returns for its investors. To achieve this, they charge a higher interest rate to borrowers through the securities they invest in.
Borrowers agree to pay a higher interest rate in order to compensate for the lower credit rating. The credit risk fund’s investment in the securities may help improve the Net Asset Value of the fund and give the securities a chance to improve their performance.
Credit risk funds generate returns in two ways:
If you are considering investing in credit risk mutual funds, here are some important features that you should keep in mind:
Investing in low rated securities comes with the apparent risk of default. In case the borrower is unable to pay out the interest amount, it further downgrades the rating of the security. Inability to pay back the principal investment results in complete investment loss for the fund.
Investing in low-rated securities is a risky business. Therefore, credit risk funds charge them a premium rate of interest. This premium results in a potentially higher interest income as compared to investments in high-rated securities.
Investments allow low-rated securities to improve their performance and move up to better credit rating. Improvement in rating also pulls up the overall valuation of the security, implying higher capital gains for the risk fund.
Low-rated securities pose serious liquidity concerns in case of defaults. It further downgrades the value of the security and it becomes difficult to sell or redeem it.
Short Term Capital Gains (STCG) are taxed according to the investor’s I-T bracket. Long Term Capital Gains (LTCG) are taxed at 20% along with indexation benefits.
Thus, credit risk funds may be tax-efficient for long-term investors, who fall in the highest tax slab (30%). However, ELSS funds offer better tax benefits (up to Rs. 1,50,000) than credit risk funds.
Read this blog to learn more about tax saving mistakes to avoid in 2021
The portfolio of credit risk funds is divided between debt securities and other market-related financial instruments. The commonality between these two kinds of investments is that the instruments have a low credit rating and offer a higher interest rate.
With such a portfolio, credit risk funds—on an average—have been known to offer 2-3% higher returns than risk-free debt investments. Also, while investing, the fund manager tries to choose securities that have a lower default probability.
However, this may seem contradictory to the fund’s underlying nature which is why investors may find it more efficient to invest in other mutual funds like:
1. Liquid funds
Credit risk funds may be suitable for investors with a high-risk appetite. As compared to other debt schemes, they have a much higher risk factor and therefore may not suit conservative investors.
Fund managers try to minimize the risk by choosing securities carefully. However, the risk of default or a downgrade in rating still exists. This can be a risky situation.
Therefore, you must speak to a Cube Wealth Coach to know if you should invest in credit risk funds. Alternatively, you can download the Cube Wealth app to get curated mutual funds based on your risk profile and investment goals.
Funds with a large corpus are in a better position to spread out their risk. It helps them mitigate risk by diversifying across securities with varying credit ratings and interest rates.
Financial advisors often recommend choosing a credit risk fund that is diversified across various securities. The portfolio of the fund should not be concentrated on any particular sector or business group.
However, it would be better for investors to speak to a Cube Wealth Coach to understand the investment and find out if credit risk funds are suitable for their portfolio.
The expense ratio of a fund is indicative of its ability to manage its expenses. It can hugely impact a fund’s net profitability. Moreover, funds that charge a higher expense ratio may eat away at the profits.
Therefore, it is important to evaluate the expense ratio of every mutual fund that you invest in. Read this blog to understand mutual fund jargon in-depth.
When it comes to credit risk funds, the experience and expertise of the fund manager become extremely important. The manager must have dealt with credit risk funds in the past and should have a good track record.
Consulting a wealth coach is important when investing in a high-risk instrument like credit risk funds. Usually, such investments should be limited to 10-20% of the overall portfolio.
Clearly, investing in credit risk funds is not an easy decision. There are a lot of risks such as interest rate risk and payment default along with other factors that need to be considered before investing.
There are relatively safer and more convenient mutual fund schemes that investors can gain access to on the Cube Wealth app. Wealth First, Cube’s mutual fund advisor, curates a list of the best mutual funds for Cube users every month.
This curated list includes:
2. Liquid funds
10. ELSS funds
Download the Cube Wealth app to get started with mutual fund schemes better than credit risk funds.
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