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What are Credit Risk Mutual Funds and Should You Invest in Them?

Highlights

  • Is it good to invest in a credit risk mutual fund that will invest a minimum of 65% in lower rated debt instruments?
  • Read this post to know what experts say on the same

A credit risk fund is a debt fund that invests in corporate bonds and commercial papers. The money you invest in a credit risk fund goes to the mutual fund company which further lends it to corporates. What makes credit risk funds distinct is that a minimum 65% of the portfolio should be invested in lower rated corporate debt. The rating of the bonds in a credit risk fund is below AA, the highest rating for a corporate bond is AAA. Companies with healthy balance sheets and good credit history have a higher rating. These ratings are reviewed regularly, and changes are made basis the company’s financial performance. A company’s rating could be upgraded or downgraded.

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How Do Credit Risk Funds Work?

  • Credit risk funds buy lower-rated bonds and target delivering 2-3% extra returns over another debt fund that has only AAA-rated bonds.
  • Usually, a credit risk fund holds 20-30 such bonds of different maturity profiles (the period in which they will mature). Therefore, these funds carry higher risks since they are not buying into the strongest companies.
  • The bet is that the operational performance of these companies will improve over a period, thus leading to a rating upgrade.
  • Rating upgrades are also dependent on the economic situation in the country.
  • As an investor, one can expect higher returns over a liquid, overnight and an AAA-rated bond portfolio.
  • However, one should carefully understand the risk of investing in these funds.
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What are the Risks in Credit Risk Funds?

  • As the name suggests, these funds have “risk” in the portfolio.
  • This risk is that of a company defaulting on interest and principal payments to the mutual fund. This could happen due to bad finances of the company.
  • Let us understand better- if a credit risk fund has 20 corporate bonds with 5% weightage each and 2 of those default i.e. cannot make interest payments to the mutual fund company, in this case, the NAV of the fund will drop to that extent.
  • If the defaulting corporate refuses to pay even the principal, the drop in NAVs will be even severe.
  • These defaults usually happen in an economic downturn. In the last 2 years, some corporates such as IL&FS, ADAG, DHFL, Essel, etc, have defaulted on payments, leading to negative returns in credit risk funds.

Should You Invest in Credit Risk Funds?

In our view, one should invest in these funds only if you have a high-risk appetite and are ready to take risks for that extra 2-3% return. Also, these funds do well when the economy is doing well since the probability of defaults is less. In the current economic situation, we would recommend one to stick with liquid, overnight and arbitrage funds only since the risk of potential defaults is still there.