Credit Risk Funds – [Overview + Guide]

In the world of investments, risk is an inherent factor that influences the potential for decent returns. Credit risk funds, while inherently riskier than other debt funds, offer the possibility of generating higher returns.

This dedicated guide on credit risk funds discusses their various aspects to help you understand their mechanism, advantages, risks & more.

What Are Credit Risk Funds?

Credit risk mutual funds are a category of debt funds that primarily focus on investing in debt instruments with lower credit ratings. These funds typically allocate a minimum of 65% of their portfolio to corporate bonds rated ‘AA’ and below.

Low-rated bonds have the potential to offer higher returns than their higher-rated counterparts, which can make them attractive to investors.

Credit risk funds operate on a unique investment strategy compared to other types of debt mutual funds, such as GILT Funds (which invest in government securities) and Corporate Bond Funds (which primarily invest in higher-rated corporate bonds).

Advantages

1. Higher Yield Potential

Companies with lower credit ratings may seek to improve their creditworthiness by making extra efforts. As a result, they may offer higher returns to attract investors. Credit risk funds have the potential to generate higher yields by accepting some additional risk.

2. Opportunity for Capital Appreciation

In addition to generating income, credit risk funds may also benefit from capital appreciation if the credit quality of the bonds in their portfolio improves.

Capital appreciation in debt funds is the increase in the value of the underlying debt instruments in which the fund invests.

3. Diversification

Fund managers have expertise in assessing the quality of lower-rated securities. These funds often maintain a diversified portfolio of bonds, which can help spread risk across various issuers and sectors. Therefore, instead of directly investing in individual bonds, it is better to opt for a credit risk fund.

Points To Consider

Credit risk funds are considered riskier than other debt funds, carrying both high credit risk and interest rate risk. Therefore, it is essential to invest in them wisely. The following points can aid in making informed investment decisions:

1. Risk Tolerance: Consider the associated risks and ensure that your risk tolerance aligns with them.
2. Diversification: Consider the diversification within the fund’s portfolio to spread risk. You can also scrutinize the credit health of individual bonds.
3. Fund’s Corpus: A fund with a larger corpus enables the fund manager to diversify across various instruments and reduce risks.
4. Manager’s Expertise: You can also evaluate the track record and expertise of the fund manager in managing credit risk.
5. Expense Ratio: Be mindful of the expense ratio, as a high one can reduce your returns.
6. Exit Strategy: Develop a predetermined exit plan with specific conditions to help guide your decision on when to exit the investment.

Final Words

The content provided is for informational purposes and readers should consult with a financial advisor or conduct their own research before making investment decisions.

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