Credit Risk Fund - How does it Work

The most distinct feature of credit risk funds is the quality of papers that they invest in. As mandated by market regulator SEBI, a chunk of their investment is into papers that are rated below AA by credit rating agencies.Such papers offer a higher rate of interest when their ratings move up, thus enhancing your gains. Also, these funds hedge against interest rate risks as the papers are held for a short duration.
Taxation of credit risk funds depends on the holding period. If held of less than three years, the gains are subjected to short-term capital gains tax (STCG). They are added to your income and taxed as per the applicable rates.On the other hand, if held for more than three years the gains are subject to long-term capital gains tax at 20% with the indexation benefit. Indexation adjusts the inflation cost during the holding period, thus reducing gains, which in turn brings down the tax liability.

There are two ways through which credit risk funds generate returns. First, they earn interest income on the securities they hold. Secondly, as they invest in lower-rated securities, in case of an upgrade, they have the potential of making capital gains. In other words, if the rating of the security held goes up, the same beefs up returns from the fund.

While investing in credit-risk funds is a good way to earn higher returns note that since they invest in lower-rated papers, liquidity can be an issue with them. In case the underlying bond faces a further downgrade, the fund manager can find it quite difficult to exit the holding.The best credit risk funds are the ones that have higher assets. With high assets, the fund manager can better diversify and spread the risk. Having said that, if you have an aggressive investor and are looking for earning higher returns than otherwise, you can bet on credit-risk funds. Knowing well the risks associated with credit risk funds can help in making an informed choice.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.