What is Credit Risk?
Before jumping in the details of a credit risk fund it is important to gain some context by understanding what credit risk entails.
Credit risk can be explained as the risk of loss that can occur when the borrower defaults on the loan and fail to repay the loan amount in a specified time frame.
Credit risk mainly arises when the borrowing party do not adhere to the terms and conditions of the loan. There are majorly 3 types of credit risks; this includes credit default risk, concentration risk, and sovereign risk. Now that we know what credit risk is let’s understand what the credit risk fund entails.
Understanding Credit Risk Fund
Credit risk fund is a type of debt fund that invests a majority of its portfolio funds, around 65-70% in less than AA-rated investment tools.
Let’s understand briefly how the rating works. Any financial instrument that has a higher rating is considered as less risky, the better the rating the lower is the risk involved. When risks are lower the return is also lower, so in case of risky assets, one can gain high returns.
The purpose of credit risk funds investing a majority of its portfolio in lower-rated financial instruments is to obtain high returns associated with high risk low rated tools.
Investment in low rated firms stock has a dual advantage; you gain from the higher interest rate and also gain from capital gains when ratings improve. Given the lower investment duration, the interest rate risk is lower. It also has the potential for investors to gain double-digit yields.
Before investing in any credit risk fund it is paramount to understand the taxation associated with these credit risk funds. Dividends distribution tax of around 29% applies to the scheme. Short term capital gains taxes are also applicable to the returns earned within 3 years.
Factors to consider before investing in a credit risk fund
Before investing in a credit risk fund it is important to analyse the pros and cons to find whether its best suited for your financial requirements or not. Credit risk funds generally have a high level of liquidity risk involved. Investors should avoid the risk of concentration by investing in a diversified portfolio. Looking out for funds with lower expense ratio is also beneficial to the investor. Let’s jump into some important considerations for investing in credit risk funds.
Investing in credit funds using diversified mutual funds is advisable, especially when you don’t have the expertise in the domain. Also, a large amount of investment in credit risk funds should be done after proper consultation as there is a high risk involved. Larger funds are advisable when investing in accrual credit risk funds.
The reason here is that the larger funds provide a safety net in terms of diversification and risk spreading. Choosing funds with lower expense ratio is the key, especially for the first time investors.
In addition to this, you should follow the general best practices in investing. You should go for well-experienced and reputable fund managers and investment firms who specialise in credit risk funds. You should always check the level of concentration of the portfolio; it should not be concentrated in securities from a specific group.
Diversification is the key to mitigating the risk here. Investors should keep the high risk-return profile of this fund and those who are risk-averse should not opt for credit risk funds as an investment tool. People who fall under high tax slabs can consider investing in credit risk funds for saving on taxes.