Credit risk funds have gained attention among debt mutual fund investors seeking higher yields. However, they come with inherent risks that require careful evaluation. Before investing, it’s crucial to assess whether the additional return justifies the risks associated with these funds.
Why Investors Consider Credit Risk Funds?
1. Higher Yields – Since these funds invest in lower-rated instruments, they offer higher interest rates, which can lead to better returns.
2. Potential for Rating Upgrades – If the credit rating of an underlying bond improves, its price appreciates, boosting the fund’s NAV.
3. Diversification – They provide an opportunity to diversify fixed-income portfolios by including relatively riskier instruments.
Risks Involved
1. Default Risk – The issuing company may fail to pay interest or principal.
2. Downgrade Risk – A credit rating downgrade can lead to bond price depreciation, impacting fund returns.
3. Liquidity Risk – Lower-rated bonds can be harder to sell in stressed market conditions.
4. Interest Rate Sensitivity – A rise in interest rates can negatively affect bond prices.
Evaluating If Returns Justify Risks
Historical Performance: Comparing credit risk funds’ historical returns with safer debt funds (such as gilt or corporate bond funds) helps assess risk-adjusted returns.
Risk-Adjusted Returns: Metrics like Sharpe Ratio or Sortino Ratio help determine whether the higher returns compensate for the additional risk.
Economic Conditions: In times of economic uncertainty, defaults and downgrades can increase, making these funds riskier.
Fund Manager’s Expertise: A skilled fund manager can navigate credit risk better by selecting quality papers with lower chances of default.
Who Should Invest?
Investors with a higher risk appetite who understand credit risk.
Those with an investment horizon of at least 3–5 years to absorb market fluctuations.
Investors looking to diversify their debt portfolio with some exposure to higher-yield bonds.
Final Verdict
Credit risk funds can provide higher returns, but they come with substantial risks. Investors must evaluate their risk tolerance, investment horizon, and market conditions before committing. If the risk-adjusted return is attractive and aligns with financial goals, they can be a good addition to a well-diversified portfolio. However, conservative investors may prefer safer debt fund options.
