What is Credit-Risk Fund
Credit-risk funds investing in lower-rating securities are gaining popularity among investors because there is a potential for double-digit yields for investors
Credit-risk Fund Meaning:
Credit-risk funds are a type of debt funds that invest approx 65% of the investment corpus in less than AA-rated paper. By taking greater credit risk and investing in lower-rated documents, they produce high returns. Such firms offer greater interest rates and offer a capital gain advantage as and when their ratings move up. The risk of interest in these funds is small because most of them are of a lower duration. Typically, these funds can return 2-3 percent greater than risk-free investments.
How are these funds going to work?
Credit-risk funds make returns on the securities they hold in two ways: first, they receive interest income. Second, since they invest in lower-rated securities, they can create capital gains if the security rating is upgraded.
Taxation of Credit-risk Funds
Dividends are exempt from tax, but a dividend distribution tax of 28.84% must be paid by the scheme. Returns you earn are subject to short-term capital gains tax within three years of investment. This will be per your income tax slab. After three years, with the advantage of indexing, you are eligible for long-term capital gains tax at 20 percent.
How should a credit risk fund be selected by investors?
Credit risk funds are associated with higher liquidity risk. If a bond with a reduced portfolio rating fails or faces another downgrade, exiting this holding may be hard for the fund manager. In this category, financial planners advise investors to select large-scale funds. Higher assets give more scope for diversifying and spreading risks to the fund manager. Investors should also look at a fund with a lower expense ratio and ensure that the portfolio in any single business group is not concentrated or has high holdings. They should select a fund manager and a fund house with good debt portfolio management experience.
Who is supposed to invest in the credit risk fund?
Despite being a debt fund, credit risk funds come with reasonable risks. For example, the lower-rated papers have also known to be downgraded to expectations sometimes. Investors should remember that these funds feature frequent rise and fall–so this is not for the weak-hearted. Investors looking for a steady income and wanting to minimize the risk factor should stay away from the credit-risk funds. People who belong to the highest tax slab who want to save on taxes can also choose to invest in credit-risk funds. They have to pay a tax on long-term capital gains of just 20% instead of 30%.
Things to consider before investing in Credit-risk Funds
- Do not make any credit-related decisions yourself, especially in larger amounts, unless you are market-savvy. Use diversified mutual funds to make these calls.
- If you invest in this type of accrual fund, select larger funds at all times. This is because their larger corpus provides them with better scope for diversification and risk spreading.
- It can be a good idea to choose a fund with a lower expense ratio, particularly for first-time investors.
- Always go with a reputable and experienced fund manager for a fund.
- Make sure the portfolio of the fund is not overly concentrated in the securities of any particular group.
Considering the above, if you have the comparatively elevated risk tolerance, you should invest in a credit-risk fund. Choosing a scheme with a large AUM is also a good idea. This will make the system less susceptible to a few big investors' sudden redemptions. The fund should have diversified investments as well as a fund manager with an established track record.