What is credit risk?
Credit risk is the risk associated with the failure of a borrower to repay back the borrowed amount. In other words, it means when a person who took a loan is unable to pay back the same within the stipulated time. Credit risk is often compensated with higher cash flows in terms of returns. A bond with a high credit risk will have a low credit rating and high coupon rates. The interest payments by the borrowers of debt is a reward for the risk taken by the lender or investors.
Lenders often assess the borrower’s credit risk based on the credit history, ability to repay, amount of loan or principal, conditions for the loan and the collateral for the loan. Huge corporates have dedicated teams to analyze the credit risk of borrowers.
However, it gets difficult for individual investors to assess credit risk. In this case, they can follow the rating of various credit rating agencies. Any rating of BBB, A, AA, AAA are considered of highest credit quality. The risk of default is very less. Ratings below BBB rating are considered to have the highest credit risk. The default rate for these is often high. Hence securities with these bonds have higher coupon rates than securities which don’t have them.
What are credit risk funds?
Credit risk funds are a type of mutual funds that invest in low rated corporate debt (fixed income) securities. The credit risk funds aim to generate higher returns by investing in securities that pay a higher yield than high rated funds. On the other hand, high rated corporate or government securities carry a lower risk.
Credit risk funds require a stable or favourable credit environment to outperform the other debt funds. As per the SEBI guidelines, credit risk funds should invest at least 65% of the assets in papers having ratings below AA+.
The bond ratings improve when the performance of the company increases. In such scenarios, the investors get higher interest rates. Also, when compared to other risk-free debt funds, credit risk funds can generate higher returns.
Credit risk funds in India have fared poorly since 2018, after the IL&FS group default. The debt crisis has become severe with multiple downgrades and defaults by other groups such as Vodafone Idea and DHFL. Since then, the assets under management have fallen from INR 80,000 crore to INR 55,000.
How does credit risk mutual fund work?
Credit risk mutual funds in India invest 65% of their assets in securities rated below AA+. These funds generate returns in two ways:
Interest Income: Investors earn interest income on the securities held by the credit risk mutual funds.
Capital Gains: They invest in lower-rated securities, and once the security gets upgraded, the investment earns capital gains.
There are good chances a borrower can default their interest payments, and in such scenarios, the security gets downgraded. This, in turn, has an impact on the fund capital gains. Eventually, the fund manager would not be able to get rid of the security resulting in low performance of the fund.
Who should invest in a credit risk mutual fund?
Since credit risk mutual funds invest in low credit rating securities, they come with a default risk attached to them. Credit risk funds earn from interest payments and capital gains if the underlying security is upgraded. However, there are more instances where the underlying security is downgraded due to its non-repayment of principal and defaulting of interest payments. These funds are very volatile.
From September 2018 credit risk mutual funds in India have been performing poorly. Since then, India is in an economic slowdown with defaults across multiple organizations and various rating downgrades. Covid-19 has only worsened the situation. Many of these funds are unable to meet the redemptions of investors due to low liquidity of these low rated papers.
Due to the high credit risk (default risk) in the category, experts recommend investors to stay away from this category of funds. Even for investors who can absorb the market volatility and have a high-risk tolerance, this isn’t the right time to invest in these funds.
Advantages and disadvantages of investing in credit risk funds
They invest in low rated securities. The risk involved in these funds is higher than funds investing in high credit rating papers. Hence they come with a premium coupon rate to compensate for the risk taken.
Benefits investors of highest income tax slab
The taxation on returns for short term capital gains is as per the income tax slab rate. However, if the investor stays invested for the long term, the capital gains are taxed at 20% with indexation benefit. Investors of the highest tax bracket (30%) will pay 10% less tax on gains.
Lack of liquidity
They lack liquidity. These papers, if downgraded, will sit tight on liquidity. It will be difficult for investors to redeem their papers. The current situation in India is the same. Since September 2018, India is facing credit crises due to defaults from major companies. Since then the redemptions are high, but there are no funds with the bond issuer to repay back the loan taken.
High credit risk
They have a risk of defaulting. There can be instances where the papers can be downgraded, leaving investors and borrowers with unpaid bonds. Credit risk funds have underlying securities of rating below BBB. These classes have the highest default rate, thus increasing the risk in the fund.
Don’t suit all investors
Credit risk funds don’t suit all investors. These are high-risk funds, and investors looking for regular and stable income should explore other options. They are only for investors with a high-risk tolerance. However, in the current market scenario, experts recommend investing in diversified funds rather than credit risk funds.
Things to consider before investing
Credit risk funds are high-risk funds. There are chances that the ratings of these funds might downgrade. Therefore they are suitable for investors who are willing to undertake the risk. Following are the things that an investor needs to keep in mind before investing in credit risk funds:
- In a scenario where the bond in a portfolio fails to improve and defaults, the fund manager faces great difficulty in exiting the security. Therefore, as an investor one needs to be aware of the risk levels associated with these funds.
- Funds with bigger AUM have a better probability at diversifying the portfolio and spreading the risk. Hence, investors should consider funds from the fund house with larger AUM.
- It is important to invest in a credit risk fund whose portfolio isn’t highly concentrated.
- A single business group should not have high possessions in the portfolio.
- The performance of a credit risk fund highly depends on the portfolio manager and the fund house. It is important to choose the funds where the portfolio manager has good experience in handling debt portfolios.
- Choose a credit risk fund with a low expense ratio.
What are the fund categories under equity funds?
Equity mutual funds are a type of mutual funds that have an asset allocation of at least 65% in stocks. Equity funds have a significant amount of risk associated with them. Hence the returns are higher in comparison to other types of mutual funds. The categories under equity funds are:
- Large Cap Funds
- Mid Cap Funds
- Large and Mid Cap Funds
- Small Cap Funds
- Multi Cap Funds
- Value Funds
- Thematic / Sector Funds
- Equity Linked Savings Scheme (ELSS – tax saver funds)
- Focused Funds
- Dividend Yield Funds
- Index funds
To know more about mutual funds, types and how they work, read our guide
Credit risk is associated with borrowers defaulting payments to the lenders. Credit risk funds invest more than 65% of their assets in securities where default risk is high. They invest in securities rated AA and below. However, to compensate for the risk taken, the coupon rates on these securities tend to be high. Thus making the credit risk fund’s returns higher than other funds. Since September 2018, the category of credit risk funds in India has taken a hit. With defaults from multiple big companies, India has gone into a debt crisis. Moreover, the credit rating of many of these securities has also been downgraded. To add to this, Covid-19 has made the situation even worse.
Therefore in the light of the current situation, Scripbox doesn’t recommend these funds due to the high credit risk.