What is credit risk fund?

New investors or those who are not very experienced with investing look for more risk-free and stable options like a diversified mutual fund. However, seasoned and experienced investors can increase their risk appetite to earn 2-3% more returns. There are numerous investment instruments capable of giving higher returns than others but demand a higher risk appetite. One high-risk, high reward investment instrument is the credit risk fund. Read on to find out more about credit risk funds and how they can be used for better returns.

Understanding Credit Risk Fund

When you invest in mutual funds, your invested capital is divided into equity funds, which includes investing in the stock market, and debt funds, which is fixed-income security that deals mainly with bonds. Bonds are given ratings based on the credit quality, the issuing company’s financial strength, and the company’s ability to pay interest and repay the principal amount. These ratings are denoted as AAA, which is the highest, then AA, A, BBB, BB, B and so forth.

Credit risk funds are a type of debt funds that mainly invest in bonds that are rated AA or lower. To be more specific, credit risk funds invest about 65% of the funds in lower than AA-rated bonds. Since these bonds do not have the financial strength of higher-rated bonds, their interest payments and principal repayment are not guaranteed. Hence the name Credit Risk Funds.

But if they’re risky, why do people invest in them? Let us explain.

How do Credit Risk Funds Generate Returns?

Credit Risk Funds reward the investors for the extra risk they take by investing in lower-rated bonds. Because credit risk mutual funds invest in lower-rated bonds, the bond issuer pays more interest to the investor. Secondly, if and when these bonds become better rated, the capital gains achieved can be high, and the investor gets higher than normal returns for their investment.

Who should invest in credit risk funds?

Despite being a type of debt fund, credit risk funds have high associated risks. It is entirely possible that instead of the bond ratings improving, they go further down. This volatility is part of credit risk funds, and only those investors with a high appetite for risk should invest in credit risk funds. Investors looking for low risk and relatively stable forms of investment that give average but steady returns should avoid credit risk fund.

Taxation of credit risk funds

Since credit risk funds are a type of debt funds, they’re taxed as short term capital gains for up to three years and as long term capital gains for more than three years. The short term gains tax is according to the income tax slab of the investor. The long-term gains tax for debt funds is 20%.

Conclusion

To conclude, credit risk funds can be a good way to earn higher than normal returns by investing in lower-rated bonds. But, as is the case with almost all investments, if the potential for profits is high, the associated risks are high too. If you are willing to take those risks to get excellent returns, then these credit risk funds might be your cup of tea. However, it is advised that you do extensive research about the company and bonds before investing in Credit Risk Funds.