A bond is a debt instrument issued by the government or by corporations for a fixed tenure. The aim motive behind issuing a bond is to raise money. The bond issuer promises to pay the investor money at regular intervals. On the other hand, a credit fund is a type of debt mutual fund that invests in bonds with low ratings. Thus, credit funds are high risk funds. Low rating bonds have a greater probability of default and thus offer a higher yield. This article covers bonds vs credit funds in detail.
What is Credit Fund?
Credit funds are mutual funds that invest in corporate debt instruments that have a low credit rating. Credit funds try to generate returns by investing in securities with a greater yield than high-rated bonds.
On the other hand, government bonds or bonds with high ratings carry a lower risk. According to SEBI’s mandate, credit funds must invest at least 65% of their assets in bonds with ratings below AA+. To generate better returns, credit funds use the accrual strategy.
Accrual strategy entails purchasing a bond with a low credit rating and hoping that its rating will improve over time. Thus, the fund manager adds bonds with low ratings to generate significant returns in the future.
When a company’s performance improves, its bond ratings improve as well. Also, credit funds have a good potential to generate higher returns than other debt funds.
Credit fund gains are taxable in the same way as debt mutual funds. The capital gains are taxed based on the investment duration.
Capital gains are taxable at your income tax bracket rate if the investment holding period is less than three years. While, if the holding period is more than three years, the capital gains attract long term capital gains (LTCG) tax of 20% with indexation benefit.
However, from April 1st 2023, LTCG benefit is no longer available for debt mutual funds. Capital gains arising from debt fund investments from April 1st 2023, will be taxable as per the investor’s applicable tax slab.
Who Should Invest in Credit Funds?
Credit mutual funds carry a default risk because they invest in securities with low credit ratings. Credit funds profit from interest payments and capital gains if the underlying security is upgraded. On the other hand, there have been instances where the bond ratings were downgraded.
This may be due to non-repayment of principal and defaulting of interest payments. Thus, credit funds are highly volatile.
Since these funds carry high risk, they are not suitable for investors who prefer low-risk investments.
Furthermore, credit funds do not offer regular income. Thus, investors who are not seeking regular income from their investments and are comfortable with the risk levels can consider investing in credit funds.
Bond vs Credit Funds
Following are the key differences between bond and credit funds:
|Basis of Difference||Bonds||Credit Funds|
|Definition||Companies or government institutions issue bonds for a specific duration to raise money.||Credit funds are open-ended debt mutual funds that invest at least 65% of their assets in bonds with ratings below AA+.|
|Maturity Date||Bonds have a set maturity date.||Credit funds have no maturity date as they hold bonds with varying maturities.|
|Returns||Bonds are a type of fixed-income scheme. They offer regular income to the bondholder in the form of interest payments.||Credit funds do not guarantee returns. Since these funds invest in bonds with low ratings, they are high-risk investments.|
|Principal Protection||When investing in a bond, you will know exactly how much money (principal) you will receive at the end of the bond’s term.||Since credit funds have no maturity date, their prices fluctuate daily. The NAV of the credit funds fluctuates daily. Also, since these funds invest in bonds with low ratings, there is no principal guarantee.|
|Liquidity||Bonds, like stocks, trade on the secondary market after they are issued. However, they are less liquid due to the small trade volumes.||Credit funds lack liquidity. If the bond papers are downgraded, they become illiquid. Thus, it becomes difficult for you to redeem your investments.|
|Credit Risk||Bonds with higher ratings have less probability of default.||Credit funds are high-risk investment options. Since the fund invests in low rating bonds, the bond issuer default is likely.|
|Portfolio Management||You shortlist, purchase and sell the bonds on your own.||Professional fund managers manage credit funds. After thorough research, these fund managers construct the credit fund portfolio and pick bonds that fit the fund’s investment objective.|
|Expense||There are no additional charges associated with bond investing.||Credit funds have management costs and other fees since professionals manage the fund portfolio.|
|Accessibility||Bonds, unlike stocks, are not readily available to retail investors. Bonds are bought over-the-counter, which makes the process time-consuming for retail investors.||You can buy and sell credit funds easily through the asset management company or through online intermediaries and distributors.|
|Diversification||To achieve diversification, you must invest in different bonds individually.||By investing in a credit fund, you will get access to a basket of low rated bonds.|