What are Credit Risk Funds and What Type of Investor are They Suited To?

In the world of mutual fund investments, debt funds are considered to carry relatively lower risk than equity investments, making them suitable for conservative investors who prioritise risk mitigation over return potential.

However, credit risk funds offer investors opportunity to earn superior returns to most other fixed-income instruments – but with higher risk.

Let’s take a closer look at what credit risk funds are, their features, and who they may be suitable for. Understanding the features of credit risk can help you make better investment decisions.

• Table of contents

1. Understanding credit risk
2. Characteristics of credit risk funds
3. Types of investors who can consider credit risk funds

Understanding credit risk

Credit risk refers to the possibility or probability that a borrower will not repay the money they owe. When you invest in a debt fund, you are essentially lending money to companies or the government.

Credit risk funds predominantly invest in companies that have a credit rating of AA and below (this is one grade below the highest credit rating of AAA). This means there is a higher probability that these companies might not be able to pay back their loans on time or at all. Because of this higher risk, these funds can offer higher returns. 

Characteristics of credit risk funds

Credit risk funds have the following key features:

• Investment in lower-rated companies: They invest at least 65% of their money in companies with relatively lower credit ratings, which means a higher risk of default than top-rated firms.
• Relatively higher return potential: These funds often provide higher return potential compared to other debt funds as compensation for the increased risk.
• Potential for better returns: Credit risk funds have the potential for better returns, but they can also be more volatile, meaning their value can go up and down significantly and frequently.
• Diversification: These funds typically diversify their investments across various lower-rated companies to spread the risk and avoid heavy losses from any single default.
• Credit rating monitoring: Fund managers continuously monitor the credit ratings of the companies they invest in to manage and mitigate risks effectively.

Types of investors who can consider credit risk funds

Credit risk funds are suited to investors who are willing to take on more risk for the possibility of higher returns.

Here are some types of investors who might consider credit risk funds:

• Experienced investors: People who have a good understanding of the market and are aware of the risks involved. They can make informed decisions and manage their investments wisely.
• Risk-tolerant investors: Those who are comfortable with the idea that they might lose some or all of their investment. These investors are often looking for higher returns and are willing to accept the associated risks.
• Diversifiers: Investors who want to diversify their portfolio by adding a high-risk, high-reward component. Including credit risk funds can balance the overall risk and return profile of their investment portfolio.
• Income seekers: Investors looking for higher interest income in the fund compared to traditional debt funds might find credit risk funds appealing due to their higher yield potential.

By matching their risk tolerance and investment goals with these characteristics, investors can decide if credit risk funds are a suitable addition to their portfolios.

Conclusion

Credit risk funds can be suitable for investors who are looking for higher returns and are willing to take on more risk. It is important to understand the features and risks of these funds to make informed investment decisions. It is recommended that you consult a financial advisor before making investment decisions.

FAQs

What are credit risk funds?
Credit risk funds are mutual funds that invest in companies with relatively lower credit ratings (AA and below), offering higher returns potential but also carrying higher risk.

How do credit risk funds differ from other types of debt funds?
Credit risk is the risk of default on loan or interest payments by the bond issuer. Credit risk funds invest in lower-rated companies, which means they have higher potential returns and higher risk compared to other debt funds that invest predominantly in top-rated securities.

What factors should investors consider before investing in credit risk funds?
Investors should consider their risk tolerance, investment horizon, market understanding, and need for diversification before investing in credit risk funds.

What are the potential risks associated with credit risk funds?
The main risk is that the companies invested in may default on their loans, leading to potential losses for investors. Additionally, these funds also face interest rate risk, which affects all debt securities. This is the risk that an increase in prevailing interest rates in the economy will cause the value of bonds to fall.
Other than that, credit risk funds are also vulnerable to market risks that apply to all investments, such as volatility, economic downturns, geo-political factors and the like.

How do credit risk funds generate higher yields compared to other debt funds?
Credit risk funds offer higher yield potential because they invest in companies with lower credit ratings that pay higher interest rates to borrow money due to the higher risk of default.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.