Credit Risk Funds: Definition, Features, Benefits and Tax Rules

A credit risk fund can be defined as a type of mutual fund that invest predominantly in corporate bonds that have a relatively lower credit rating. SEBI guidelines also specify the limit of these low quality investments. As per current rules, at least 65% of the portfolio of a credit risk fund needs to consist of corporate bonds rated AA or lower. This means that a majority of investments by the scheme are made in relatively low quality debt instruments that have potentially higher credit risk.

So, the name of these funds is based on the high credit risk associated with the underlying investments, as lower-rated bonds tend to carry a higher risk of default. On the flip side, this increased risk also means that the investments made by credit risk schemes will have a higher coupon rate resulting in potentially higher yields for the investor. This is the basis of the potentially higher returns that these debt funds can generate as compared to other low risk debt fund options such as liquid funds , ultra-short duration funds and gilt funds .

From the credit risk fund definition mentioned above, the following are some key features that investors should keep in mind:

•  Investment focus: These funds primarily invest in corporate bonds with a credit rating of AA or lower. The objective is to get higher coupon rates and generating higher yields to leverage the risk-return trade-off for investors.
•  Risk management: While inherently riskier, credit risk funds are managed by professional fund managers who employ strategies to mitigate and manage credit risk. This includes thorough research, diversification, and ongoing monitoring.
•   Potential for high returns:The allure of credit risk funds lies in their potential to offer higher returns compared to most traditional fixed-income investments. However, investors must be aware of and comfortable with the associated risks.
•   Higher Credit and Liquidity Risk: Low quality bond investments carry higher credit risk as the chances of default by the bond issuer is higher. Additionally, this can result in lower liquidity for these bonds as the number of buyers for such potentially high risk debt instruments tends to be limited.

In view of the above, it is natural to wonder why investors would want to take on the additional risk. The below benefits of credit risk mutual funds should shed some light on this investment option:

Below are some of the key reasons why investors should consider investing in credit risk funds:

The taxation of credit risk funds is an essential aspect that investors must consider.tax treatment of mutual funds in this category varies based on the holding period and the nature of the gains. Here's an overview:

Investing in credit risk funds carries certain risks that must be acknowledged to make informed decisions. Here are some of the critical risk factors to consider:

While Credit Risk Funds can be a unique addition to an investment portfolio, but they might not be suitable for everyone. Here are a few categories of individuals who can consider investing in these funds:

•  Risk-tolerant investors: As the name suggests, credit risk funds come with a higher degree of risk. They are suitable for investors who understand and are comfortable with the associated risks.
•  Income seekers: These funds can be a source of regular income, making them suitable for retirees or others looking for consistent income streams.
•   Diversification seekers: Credit risk funds can add a layer of diversification to a portfolio, complementing other low-risk and potentially low returns investments.