Credit Risk Funds are type of Debt funds that lends money to risky assets. According to SEBI's rule, Credit Risk Fund should have minimum of 65% assets that have credit ratings below AA. This rule was revised in May 2020 to 50% due to liquidity issues in Credit Risk Funds (Franklin Debt Crisis). One might say that debt funds are for risk aversion and this debt fund itself is risky. Isn't this ironical? Let's understand what role does Credit Risk Fund play in the system.
Many companies faces problems in their business and requires money to come out of these problems. Now, due to poor current condition of the business the credit ratings of these companies i.e their ability to pay back the lended money deteriorates. But these companies may face problems due to short-term issues and can recover or turnaround if they get enough liquidity to strengthen their business back. For example, Vodafone Idea is facing huge losses today but once it was the leader in telecom sector. Their credit ratings are junk but if they get enough money to strengthen their business back, they have the ability to turnaround and perform well. The probability of this to happen is less and hence they have to borrow money on higher interest rates. The investor in Credit Risk Fund wants to take this risk for additional 2-4% returns i.e 8-12% and lends money to risky companies (high risk, high returns). To protect investors fund, investment in risky assets are restricted to 50% and remaining 50% are invested in safe bets like government securities, treasury bills and high-rated debt instruments.
Equity investment versus Credit Risk Fund : The difference of risk in both is that equity investments are volatile i.e they can lose huge value (say 50%) and recover back. Markets are irrational in equity investments but incase of credit risk funds they will lose value only if companies start defaulting on debts. From past experiences one can say that Credit Risk Funds are very risky during economic crisis (2000, 2008, 2020) as the probability for companies to default raises exponentially. Note that it is like taking risks on an unknown path vs taking risks on fixed path. If the car dashes (risk) you on any path, it is certain for your medical emergency. If you need to withdraw the money invested in near future of about 2-3 years, it is better to invest in Credit Risk Funds as Liquidity will be available here whereas in equity you might need to book a huge loss for withdrawing money.
Taxation : As they are debt funds, they will be taxed according to the tax rules for debt funds. For withdrawing gains before 3 years (Short Term Capital Gains), taxes will be as per income tax bracket. For withdrawing gains after 3 years (Long Term Capital Gains), taxes will be 20% after indexation (considering inflation).
Important Factors for choosing Credit Risk Funds : The most important factor for choosing Credit Risk Funds is to check the size of the fund (Assets under management). This is important as larger the fund, less is the chance of asset/liability mismatch i.e if companies start defaulting and investors start withdrawing money simultaneously, it creates a liquidity crisis for the fund. In this situation, credit risk funds have to borrow money from other sources to give back to investors which also has limitation. The final outcome is to close the fund. Other important factors are expense ratio and definitely returns. As you are taking extra risk, past history of at least 5-8 years of returns matters. Also, less the expense ratio, better is the fund managed. One more thing that is important is to know is the past track records of defaults with funds. This information is not easily available online. One needs to interact with fund management to know this as of now.
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