Are credit risk funds worth your investment? Things to know before you invest

Debt mutual funds are a good investment option if your risk appetite is low and you want to book relatively assured returns from the share market. But, what if you are prepared to take a considerable risk while staying invested in debt-based instruments? You most likely would choose credit risk funds in such a scenario.

After all, credit risk funds are debt funds that invest your money in debt securities of low-credit quality. As a result, the risk of default is high and in exchange, you get higher returns compared to your average debt funds in the mutual fund scheme. But do credit funds deliver what they promise?

Let’s take a look at some parameters that you must consider before investing in credit risk funds.

Portfolio

The very first thing to review before investing in a credit risk fund is its portfolio. By definition, credit risk funds are supposed to invest 65% or more of their capital in low-credit quality securities and money market instruments. This means a majority of the portfolio of credit funds should comprise of securities with a rating of AA or less. Unfortunately, this is not the case with some of the popular credit risk funds available in the market.

Average returns

On average, credit risk funds can offer 2-3% higher returns than low or no-risk debt funds. The top credit risk funds offer a return of 8-10% in a 3-year investment window. These returns are also impacted by the average expense ratio, which could be anywhere between the range of 0.75% to 1.25%. Also, if you have selected the credit risk fund direct growth option, any potential bonus or profit payout gets reinvested to increase your net returns.

Performance

The performance of credit funds is dependent on the performance of low credit quality securities and the fund manager. As the component securities of your fund improve in their credit rating, the overall performance of the fund improves too.

Finally, once you secure the returns from your credit risk fund, they attract a long-term capital gain tax of 20%. This is because it is recommended that these funds are held for an investment window of a minimum of two years to correct any defaults and acquire sufficient returns.

Should you invest in credit risk funds?

The fact that you can make better returns with a much shorter holding period and associated tax liability, tends to make credit risk funds a less than optimal investment option for your money. If you are willing to bear some risk for higher returns, equity-linked mutual funds are a better option. If you want to explore low-quality credit securities, the ultra-short-term category could give you better exposure.