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Investors in debt mutual funds and bank fixed deposits are in a dilemma. With FDs giving decent returns, does it make sense to invest in debt funds? But there is one debt mutual fund that provides greater returns than other debt funds, as well as fixed deposits. And that is credit risk funds. However, despite being a debt mutual fund, the credit risk fund carries the maximum level of risk among debt mutual funds. Hence, before investing one should understand the product. Let’s take a look at what investors should know before investing in this debt fund:

Credit-risk mutual funds are not for everyone as they carry high risk in exchange for extra returns.

What are credit risk funds?

Credit risk mutual funds are open-ended debt funds that invest in corporate bonds with lesser credit ratings that typically offer high yields. However, as these funds invest in low-quality bonds, they have been linked with a higher risk.

Credit risk is the risk of default that an investor assumes if the issuer of a fixed-income security cannot timely repay the principal or interest.

According to financial experts, instruments with a credit rating lower than AA+ bear a greater credit risk. Frequently, fund managers of credit risk funds choose securities that they believe will experience an improvement in ratings. If their calls on the corporate instruments are successful, their returns will increase. Nonetheless, this is not always the guarantee.

Risk factor

The episode of Franklin Templeton Mutual Fund in India winding up of six yield-oriented, managed credit funds, effective from April 23, 2020, was an unforgettable event in the investors’ minds.

That said, portfolios focused on credit risk are typically illiquid due to their substantial exposure to lower-rated securities. When such funds experience significant redemptions, they may run into difficulties.

In the event of a default or downgrading and winding up, the impact on the Net Asset Value (NAV) of the scheme will be significant and may potentially result in redemption pressure.

Taxation

Credit risk funds are taxed as a debt mutual fund. Debt fund investments will no longer be eligible for the LTCG indexation benefit as of April 1, 2023. Instead, the gains of the investor will be taxed as part of their taxable income. No matter how long debt fund units were held, all profits on newly purchased units after April 1, 2023, will be considered STCG.

Returns

As per Ace mutual fund, the credit risk fund has given an average return of 8%,9%, and 5% in the last 1,3 and 5 years, respectively, as of October 31, 2023.

Should you invest?

Among debt funds, credit risk funds are riskier since they may allocate a portion of their portfolio to underrated companies. Credit risk funds are, therefore, chosen by investors who wish to take on some risk in addition to higher rewards.

Furthermore, liquidity is a significant issue because India does not yet have a secondary market for lower-rated debt securities, which makes portfolio churning and occasionally even meeting redemptions very difficult.

Consider well-diversified funds across issuers and companies when selecting a credit risk fund. Investors should also consider the size of the fund and portfolio diversification at the time of investment. Maintain a diverse debt fund portfolio as well. Investors should take into account the fund management team’s stability, experience, and tenor as well.

Conclusion

If investors want to invest in these mutual fund schemes, they must decide what their financial objectives are and create a plan to achieve them. Just for that extra 2-3% higher returns as compared to risk-free debt funds, investors should not invest in credit risk funds. The help of a financial planner is recommended before investing in these funds.