Credit Funds: Credit funds are also known as credit opportunity funds or credit risk funds are debt mutual fund schemes that invest in securities/bonds that have a lower credit rating. Simply put, these funds’ portfolios are heavily weighted toward riskier debt instruments, and the possibility of their issuers defaulting on debts cannot be fully ruled out.
Approximately 65-70 percent of credit fund underlying instruments are rated AA or below. Because of the increased level of risk, these low-rated securities tend to give larger returns in order to compensate investors for the risks they assume.
Returns on credit funds are frequently greater than returns on normal debt funds that invest in high-rated debt documents. However, the risk of default in certain of the underlying assets is higher, therefore investors should proceed with caution while selecting and investing in credit funds.
Having said that, fund managers usually try to mitigate and restrict risks by making investment selections based on in-depth research of the borrower’s (the bond issuer’s) financial characteristics, company growth prospects and analyzing such issuers’ repayment capacities on maturity. The timely evaluation of securities assists fund managers in balancing portfolios. As a result, the potential of these funds to deliver comparatively greater returns while closely managing risk variables makes them a good alternative for investors with a larger risk appetite in the debt category.
Benefits of Credit Funds
Credit risk funds outperform traditional debt investments such as fixed deposits, recurring deposits, and regular income funds in terms of return generation. Furthermore, dividends (if any) are tax-free, which is not the case with many other debt instruments where earned interest is taxable. Furthermore, if the credit rating of any of the underlying assets of such funds is enhanced over time, it aids in the generation of better returns.
Disadvantages of Credit Funds
Credit opportunities funds, like other debt funds, have comparable risks.
a) Risk of Default
If the issuer of the debt papers to mutual funds’ financial health deteriorates throughout the course of investing, its ratings will be downgraded. In such cases, the net asset value (NAV) or values of the scheme’s assets under management are influenced. The investment manager conducts extensive study and due diligence to determine whether the papers are worth investing in. Regardless, issuers may still default. The good news is that all investments are not made in a single security, therefore there is no risk of default in all underlying assets.
b) Interest Rate
It is worth noting that debt security values are inversely proportional to interest rates. When interest rates fall, the value of debt securities increases, and vice versa. As a result, the interest rate trajectory will have an influence on the returns of credit risk funds, as well as any other debt funds. When interest rates are higher, it is best to invest more in debt programs to keep investment costs low.
Because low-rated securities do not attract many purchasers because they are prone to fail, these assets face a liquidity shortage, which is investment risk. The fund manager of a credit opportunities fund may not always be able to locate purchasers for the debt instruments in which he is invested. Especially when investors seek to redeem, the fund manager’s ability to sell some of the papers might assist in honoring the redemption request. As a result, credit funds have a liquidity risk.
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Preferable Exposure To Credit Risk Funds
With the above-mentioned benefits and drawbacks of credit opportunities funds, it is apparent that such schemes carry some risk, but the returns are significantly bigger when compared to traditional debt funds. Only those individuals who want to pursue greater yields on their debt assets and are willing to take on significant risk should invest in credit funds.
It is recommended that they invest up to 10% of their debt portfolio in credit funds. If one takes an aggressive approach, the allotment can be increased to 15%. Above these levels, one will wind up using a lot of leverage and deviating from the investment fundamentals of risk-adjusted return.
Furthermore, it is best to select credit risk funds that are larger in size. This will assist investors in avoiding the concentration risks associated with smaller-sized credit risk schemes. Credit risk funds are not suited for debt investors with a low to moderate risk appetite and should consequently be avoided.