What Is a Credit Risk Fund?

The world of investment is dicey, with so many options available for common people. Thus, knowing the kinds of mutual funds is imperative if you wish to make wise choices on the first go. On that note, credit risk funds are a type that has drawn interest in Indian finance. 

To be honest, credit risk funds have become more appreciated among Indian investors lately. As their name suggests, credit risk in mutual funds is focused on investing in debt products that have a high credit risk. Notably, it appears that the credit risk funds is beneficial because of their diversification in comparison to traditional fixed-income assets. They might, however, provide higher returns than other fixed-income assets, such as bank fixed deposits.

Introducing what a credit risk fund is – A brief understanding

Credit risk funds, alternatively referred to as credit risk debt funds, are a type of debt fund that primarily invests in debt securities of low credit quality. Given their allocation to lower-rated instruments, such funds have higher credit risk. However, investors may question the rationale behind investing in securities with low credit ratings. The primary motivation lies in the fact that such securities typically offer higher interest rates, compensating for the elevated risk associated with default.

These funds give investors the chance to increase the possible profits on their investments while diversifying their holdings. Every investor should be aware of the dangers and factors that are specific to them, though.

What are the top features of credit risk funds?

Here are some of the key features of credit risk funds in India that investors should be aware of:

• Predominantly invest in AA and below-rated corporate bonds
• Moderate to moderately high credit risk depending on underlying portfolio quality
• Offer returns higher than short-term and income funds
• Provide moderate liquidity depending on the portfolio maturity profile
• No assured or guaranteed returns, unlike fixed deposits
• Capital gains are taxed at 20% if held for over 36 months

Understanding risks associated with the credit risk funds

No wonder investing in lower-rated debt instruments through credit risk mutual funds has the potential to yield higher profits. Nonetheless, there are certain risks involved. That stated interest rate and sensitivity liquidity issues are a few things that investors have to deal with. Besides, there are risks associated with market volatility and credit. Thus, making a well-informed decision requires an understanding of those risks. On that note, the points below present the top risks associated with these funds:

Credit default risks

Firstly, credit risk funds predominantly invest in corporate bonds with modest credit ratings. Note that a default or credit rating downgrade of bonds may result in huge losses for the investors.

Interest rate fluctuation dangers

So, changes in interest rate levels in the economy can impact bond prices and credit risk fund NAVs. Note that a rising interest rate environment may result in a decline in the price of bonds by funds, negatively impacting returns.

Market volatility risks 

In general, credit risk funds (like debt funds) are susceptible to risks. Notably, these risks may arise from market movements and volatility in bond prices. Evidently, macroeconomic and market developments may influence the performance of credit risk funds.

Liquidity risks 

Truth be told, corporate bonds invested by the credit risk tend to be less liquid when compared to those high-rated bonds. So, that makes it more challenging to sell in desirable quantities and at optimal prices during tight liquidity. Thus, this may constrain the fund’s ability to make improvements.

Tips to consider before you invest 

When thinking about investing in credit risk funds, there are a number of important things to take into account:

Consider the duration of the fund as per your investing horizon

So, the first thing to consider is to ensure that the maturity profile of the fund aligns with the investment horizon. What you can try is opting for long-duration or medium-duration funds while planning to invest for three or more years. Note that these funds offer the potential to capitalize on the interest rates effectively.

Never neglect the power of the expense ratio

Truth be told, the expense ratio represents the annual fees and expenses. So, this directly impacts the fund returns. Note that comparing expense ratios within the category helps identify the cost-efficient choices. Nonetheless, you should compromise on quality while looking for inexpensive options. 

Assess portfolio credit quality

You also need to evaluate the credit quality of the fund’s portfolio thoroughly. For this reason, you should examine the credit profile of the securities held. Also, do not forget to assess the concentration in riskier unrated papers. Notably, a decent portfolio with a balance between higher and lower-rated securities can help manage credit risk effectively.

Consider a diversification strategy

Assessing a diversification strategy for your selected fund’s portfolio is crucial because it mitigates risks. So, look for funds that spread investments across various issuers’ credit ratings. Note that a well-diversified portfolio can reduce risks. Besides, it ensures that potential losses are also minimized.

Understand how much risk you can take

Further, you must evaluate your investment goals and risk tolerance before investing in credit risk funds. You must consider whether the potential for high returns justifies your risk and volatility. Additionally, ensure that the investment aligns with financial goals (is it long-term or for regular income). Besides, it is imperative to assess risk tolerance and investment strategies to make informed decisions.

Thus, you can ensure that you select the right investment strategy that aligns with your financial plan and risk tolerance by following these tips and tweaks.

Wrapping up

Given their potential to yield better returns, credit risk funds can be a beneficial addition to an investor’s debt portfolio. Nevertheless, there are also additional dangers. So, conducting your research before making an investing decision is crucial. You may consider some wise strategies for credit risk. 

That stated, you can keep total exposure to a minimum and diversify between schemes. Additionally, you can align the duration of your investments with fund maturity. Note that it will work the best when utilized selectively by implementing the right strategies.

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