Credit Risk Funds
Credit Risk Fund is defined as a type of debt mutual fund that invests at least 65% of its assets in corporate bonds that are rated AA and below (including lower-rated corporate bonds), excluding bonds rated above AA+.
Key Features of Credit Risk Funds
- Minimum Investment in Lower Rated Corporate Bonds: At least 65% of the fund’s assets must be invested in corporate bonds rated AA or below (excluding AA+ and above). These bonds have higher credit risk but offer higher yields.
- Higher Credit Risk: These funds carry relatively higher credit risk compared to other debt funds due to the lower credit rating of the issuers they invest in.
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- Investment Instruments: Portfolio primarily includes corporate debt (debentures, bonds, commercial papers) issued by private institutions, NBFCs, banks, financial institutions, and PSUs with ratings AA and below. They may also invest up to 35% in other debt and money market instruments and up to 10% in REITs and InvITs units.
- Risk and Return Profile: These funds aim to generate higher income and potential capital appreciation by accepting higher risk. They typically have a moderate to high-risk profile with higher interest rate risk.
- Diversification and Risk Management: Fund managers use credit research and risk management strategies to balance security selection and exposure limits. They may use derivatives to protect downside risk.
- Liquidity Norms: SEBI mandates a minimum of 10% of assets to be maintained in liquid securities like government securities, treasury bills, or cash instruments to meet liquidity needs.
- Suitability: More suited for investors with moderate to high-risk appetite and medium to long investment horizon, willing to take credit risk for enhanced yields.
- Regulatory Compliance: These funds comply with SEBI mutual fund regulations including exposure limits on single issuers and cumulative exposure through debt, derivatives, and units issued by REITs/InvITs within 100% of net assets.
How Does Credit Risk Funds Work
- Portfolio Construction: Fund managers carefully select corporate bonds, debentures, and other fixed income instruments from companies with lower credit ratings. The focus is on issuers with ratings below AA (excluding AA+ and above). These issuers carry a higher risk of default but offer higher yields.
- Credit Analysis: The fund’s management team uses in-house credit research and analysis to assess the creditworthiness of different issuers. They monitor factors such as the issuer’s financial health, industry conditions, and macroeconomic influences to manage and mitigate credit risk effectively.
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- Risk/Return Balancing: By investing in these lower-rated securities, the fund takes on more credit risk than typical debt funds but aims to achieve higher returns. If the credit quality of the bonds improves (i.e., they get upgraded), the fund may gain capital appreciation along with the high interest income.
- Diversification and Risk Controls: Fund managers diversify across multiple issuers and sectors to reduce the risk of default impacting the entire portfolio. They also set exposure limits per issuer and may use derivatives for risk management.
- Liquidity and Redemption: SEBI guidelines require these funds to maintain a minimum of 10% in liquid instruments like government securities or treasury bills to meet liquidity needs and redemption requests.
- Investor Returns: Investors earn returns from two main sources—interest income from the corporate bonds and potential capital gains if the credit ratings of the invested securities improve over time.
Pros And Cons
Pros
- Higher Returns Potential: These funds invest in lower-rated corporate bonds that offer higher yields compared to high-credit-quality bonds, leading to potentially better returns than traditional debt funds.
- Diversification: They provide a diversified portfolio across various issuers, sectors, and credit quality, helping spread and mitigate risk.
- Capital Appreciation: Investors can benefit from capital gains if the credit ratings of the invested securities improve over time.
- Steady Income: They generate regular interest income from the higher-yielding bonds in the portfolio.
- Active Management Expertise: Managed by professional fund managers using in-depth credit research to pick bonds and manage risk, providing investors expert oversight.
- Suitable for Medium to Long-term Investment: They tend to perform better over a longer horizon due to potential credit upgrades and risk adjustment.
Cons
- Higher Credit Risk: These funds have a higher chance of default or downgrade as they invest in lower-rated bonds, risking capital loss.
- Volatility: Greater price volatility compared to high-rated debt funds due to credit events and market sentiment shifts.
- Liquidity Risk: Lower-rated bonds can be less liquid, making it harder to sell them quickly without impacting prices, especially during stressed market conditions.
- Higher Expense Ratios: Management fees are typically higher due to the extensive research and active risk management required.
- No Guarantee of Success: Performance depends on fund manager skill and market credit conditions; returns are not guaranteed.
