Credit Risk funds are a special category of debt funds which invest at least 65% of the portfolio in below highest-rated corporate bonds. In other words, such funds invest predominantly in AA or below rated debt securities. As at 30th September 2018, credit risk funds’ Assets Under Management (AUM) across the industry amounted to Rs. 89,700 crores. (Source: CRISIL Research).

Such funds typically generate returns through two ways:

1. Accrual Income – Fixed income securities in which such funds invest entitle the investors for pre-determined interest on a periodical basis. While the interest may be payable on quarterly, semi-annually or annually, the accrued interest for each day gets factored in the market price of the securities. As such, the investors gain through an increase in valuations due to interest accrual.

2. Rating Upgrades – Since such funds invest in below highest rated bonds, the portfolio carries a potential for capital appreciation through rating upgrades.

What is Credit Risk?

It refers to the risk of default by the issuing company. In simple words, it denotes the risk that the issuer company will not be able to service its debt obligations including payment of principal and interest on due dates. The credit ratings of the issuer companies tend to reflect the credit risk associated with the securities issued by those companies.

Different Credit rating agencies issue credit ratings across several grades which can range from AAA (which conveys the highest level of safety concerning payments by the issuing company) to D (conveying a high probability of default). So, this means that an AAA-rated bond will reflect lower credit risk and thus, fetch better valuations in the market than an A-rated bond with similar coupon rates, as the investors will be inclined to invest in a better-rated instrument.

Credit Risk Premium

The credit risk premium (commonly referred to as ‘credit spread’) needs to be directly proportional to the credit risk associated with such investments, as the investors need to be suitably compensated for the higher credit risk. So, the credit risk premium increases, as one moves southwards across the credit rating grades. The table below reflects the credit spreads as at the end of March 2019:

Source: CRISIL

Since credit risk funds invest a higher proportion of the portfolio in below highest rated instruments, the investors are benefited with higher interest rates due to higher credit spreads.

The Real Risk in Credit Risk Funds

In the pursuit of getting better yields, debt funds may invest in a higher proportion of low-rated bonds, which have a higher probability of default as well. As such, the investors may be exposed to a higher risk than warranted. Further, such funds expose the investors to high liquidity risk, as the liquidity of debt security tends to dry up quite significantly in case of a further downgrade or default of a low rated paper. As such, it may get difficult for the fund manager to exit the debt security bond at a reasonable price and instead, may have to sell that at a steep discount.

Mitigation of Investment Risks

While the word ‘credit risk’ may signify a risky investment prima facie, a credit risk fund manages the credit risks through a diversified credit portfolio across different credit ratings and sectors and making informed investment decisions after due research and analysis. Further, the funds generally may have internal limits for exposure to a particular company/ group/ sector, so that any adverse event may not significantly impact the portfolio returns.

Taxation for Debt Funds

The returns from credit risk funds are taxed as Capital Gains in the hands of investors. The gains will be classified as long-term capital gains if the investment in such debt funds has been for 36 months or more. For an investment with a shorter period, the gains are taxed as short-term capital gains. Short term capital gains are added to the regular income of the investors and taxed as per the tax rates as applicable to the investor.

On the other hand, long-term capital gains on debt funds are taxed at the rate of 20% after indexation. The benefit of indexation allows the investors to adjust the actual amount invested with the inflation rate as per the Cost Inflation Index (CII) notified by the Income Tax Department. As such, the effective tax rate on actual returns would be even lesser than 20% since the taxable gains will be computed from the indexed cost.

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