Credit Risk Funds

Prior to SEBI’s huge mutual fund reclassification circular in October 2017, Credit Risk Funds were termed ‘Credit Opportunities Funds’.

Can you observe the shift in attitude?

The Credit Opportunity Fund has a strong focus on providing potential rewards and a more positive outlook, making it an attractive choice to potential investors.

The Credit Fund is a sensible option, yet its inherent nature requires highlighting of the risk involved. It is prudent to do so, in order to ensure that potential investors are aware.

The name ‘Credit risk fund’ should give you an indication of what this fund involves.

As expected, the fund is rife with Credit Risk!

Let us begin with a definition from the Securities and Exchange Board of India (SEBI):

If you’re curious about the small circumflex that appears beside the name,

SEBI here stipulates that an AMC running a credit risk fund should invest 65% of the assets in corporate bonds, which are rating AA* and below investment grade, signifying that –

The potential for default or a downgrade in the credit rating by the bond issuer is considerable, making these bonds highly vulnerable to credit risk.

It is not specified where the remaining 35% of funds is to be invested.

The Credit risk fund is where the fund managers take advantage of yield opportunities. Picture it like a child at a buffet – they will overload their plate, with absolutely no restraint on what’s put onto it.

A fund manager running a credit risk fund may load up the portfolio with risky papers in order to pursue higher yields. To elaborate,

The aim of a credit risk fund is to maximise credit risk in order to provide investors with a higher return. What does this signify?

The fund will lend the investor’s funds to corporates, who have a dubious repayment track record or repayment capability. This could put the fund manager in an uncertain position as to whether they will get their money back.

The corporates seeking the fund have promised higher interest rates in exchange for the money.

One understands the issue; organizations with poor credit history must entice new creditors with a higher interest rate.

In the case of firms with lower ratings, fund managers typically expect certain things. They might hope for a positive return on their investment, minimal risk, and improved creditworthiness.

The borrowing entity will repay and fulfil their obligation to pay interest regularly.

He also wishes that the company will enhance its creditworthiness.

If the creditworthiness becomes better, the rating of the bond/paper will increase.

As ratings improve, bond prices rise and consequently the NAV goes up.

If these circumstances materialise, the fund manager will receive interest rates above normal, in addition to a credit rating boost plus increased bond prices.

Let us look at a portfolio of a Credit Risk Fund; this belongs to DSP’s Credit Risk fund –

The fund manager here has allocated a substantial portion of assets to a single company. If there is any default on the obligations of this firm, it could have a dramatic effect on the NAV of this fund.

The credit ratings of the other companies aren’t great, as is to be expected from a risk fund. The combination of concentrated positions and subpar scores makes investing in this kind of fund very precarious.

The credit risk fund can be tough to comprehend, but the good news is that retail investors don’t have to struggle with this issue.

Retail investors can attain their portfolio goals without putting their money in a credit risk fund; thus, it is not recommended to invest in one.