With the recent credit downgrades/ defaults by several companies adversely hitting the returns from credit risk funds, it is important to take informed decision before investing in these funds.
Credit risk funds are debt funds, which have to invest at least 65% of their total assets in investments below highest rated instruments. These funds found a lot of favour among retail investors due to their ability to generate higher returns than most debt fund categories. With the recent credit downgrades/ defaults by several companies adversely hitting the returns from credit risk funds, it is important to take informed decision before investing in these funds. Here are some of the crucial factors that investors need to know before investing in a credit risk fund.
Higher potential of accrual income
Fixed income securities with lower credit rating offer higher coupon rates to compensate investors for taking higher risk. As credit risk funds primarily invest in corporate bonds with lower credit ratings, their portfolio constituents earn higher interest income.
Potential of capital gains on rating upgrade
The rating agencies assign credit ratings to bond issuers on the basis of their ability to service debt. As and when a bond issuer registers an improvement in their debt servicing capacity and their overall business fundamentals, the rating agencies take note of that and improve the credit rating of the issuer. Any consequent improvement in the credit rating then leads the bond prices to move up. However, if any of the lower-rated paper held by a credit risk fund undergoes further credit downgrade, it would adversely impact the NAV and liquidity of the fund.
Higher liquidity risk
Given the type of bonds they invest in, credit risk funds have higher liquidity risk than other debt fund categories. Low-rated corporate bonds suffer from low liquidity. If such bonds face further downgrade or defaults, it may become difficult for the fund to exit those bonds. This may lead NAV of the concerned fund to go down.
Higher credit risk
Credit risk refers to the risk of a bond issuer defaulting on the repayment of its interest or principal amount. As credit risk funds have to invest at least 65% of their total assets in bonds having lower than the highest credit rating, they usually have highest credit risk among various debt fund categories. Hence, investors should carefully go through the portfolio of credit risk fund to check whether the fund has high exposure to any single bond issuer. The more diversified the portfolio is, the lower the credit risk from a credit incident.
Credit risk funds usually bet on the probability of credit upgrades of their portfolio constituents. However, a company gets credit rating upgrade only after a steady improvement in its fundamentals, which in itself can take up to several financial quarters. Thus, opt for credit risk fund only if you can afford an investment horizon of at least three years.
Check the duration risk
Modified duration refers to the price sensitivity of debt instrument with respect to the interest rate movements. The higher the duration number, the higher the sensitiveness of a debt investment to interest rates changes. For example, if a debt fund mentions its modified duration as four years, then its NAV will decrease by 4% in the event of a 1% increase in interest rates.
Gains booked within three years of investment in a credit risk fund is considered as Short-Term Capital Gains (STCG) and taxed as per the tax slab of the investor. Those booked after three years are considered Long term Capital Gains (LTCG) and taxed at 20% with indexation benefits. While dividends paid by credit risk funds are not taxable per se at the hands of the investors, funds pay a Dividend Distribution Tax (DDT) of 29.12% on the amount set aside for dividend payment.
The writer is CEO& co-founder, Paisabazaar.com