There is a well-known saying in the world of finance – ‘Higher the risk, higher the return’. Young investors are uniquely positioned to take risks since they have a longer life ahead of them to recover from their mistakes. Hence it’s no surprise that credit funds are trusted by many young investors for their high return potential.
Credit funds are debt mutual funds wherein the fund manager invests the corpus in the fixed income segments such as corporate papers, and bonds with ratings lower than AA floated by companies, which have a lower rating but provide high returns.
Salient features of credit funds
-The fund corpus is invested in debt instruments and fixed income segment based on their credit grade.
-The investment is more focused on returns than the quality of investment, therefore its risk is higher than other debt funds
-Fund managers play with the credit risk of companies to earn a higher return, therefore the default risk of investment by such funds is high if the credit ratings of companies invested in slide lower
-There is an exit load on premature withdrawal of investment.
What are the benefits?
-Despite the higher risk, credit funds are gaining popularity in India. Following are some of the key benefits of investing in credit funds:
-Return on investment is higher than prevailing interest rates or other debt funds.
-Fund managers invest in a corporate bond only after studying a company’s financial report, assessing risk, and understanding the company’s prospects.
-It delivers a higher return on the principal of accrual strategy, i.e. if the credit rating of a company improves then the returns on its commercial papers automatically increase. For example, a fund invests in ‘A’ rated bonds and after few months the rating of bond improves to ‘AA’ grade.
-Automatically, the return on such bond would increase as the risk factor diminishes.
– It is less influenced by the interest rate risk, therefore investors prefer it.
Why young investors should invest in credit funds
The young investor seeks high returns. He is ready to take financial risks. Therefore credit funds fit well with his profile. Following are some more reasons for young investors to invest in the credit funds:
-Return expectation is high despite lower interest rate in the debt market
-It allows diversification by investing in lower-rated corporate bonds on the basis of the credit grade
– The past few years’ performance has been good in comparison to returns from fixed deposits and other debt products
It provides opportunity to invest in the lesser-explored lower grade bond market
Tax liability on credit fund investment
– The tax liability on returns from credit fund investment is similar to other debt funds. For short-term capital gain (< 3 years) it is taxed according to the investor’s respective slab rate. For long-term capital gain (> 3 Years), it is taxed at 20% with indexation.
What are the risks of investing in credit funds?
Credit funds carry the following risks:
– The chance of default risk is very high because credit funds invest in lower-rated bonds and commercial papers. If a company defaults in payments, it adversely impacts a credit fund’s NAV.
– Liquidity is low as companies also charge an exit load on premature withdrawal
-Fund managers can also invest in a low rated bond, i.e. as low as ‘A-‘ therefore the investment quality can deteriorate further after making the investment
-There are very few credit funds available in the market therefore a comparison of funds can be done only to a limit
Things to keep in mind while investing in credit funds
-Always invest in a fund with large assets under management (AUM) as it would provide easy liquidity at the time of exit
-Study the investment pattern of a fund. If it invests in inferior bonds which are highly risky then you can avoid such a fund
-Analyse the past record of the fund and check the return history
-Invest for a definite period to avoid exit load levied on premature withdrawal
The author is CEO, BankBazaar.com.