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Everything you need to know about credit risk mutual funds

debt mf
Credit risk funds are a category of debt mutual funds that invest at least 65 per cent of their portfolio in lower than AA-rated papers. According to the Sebi definition, credit risk funds are open-ended debt schemes investing in below the highest-rated corporate bonds. This means that these schemes can generate high returns by taking higher credit risk. Lower-rated papers generate high returns when their ratings move up. However, there are also chances of downgrades and defaults in these papers as we have seen recently.

Credit-risk funds make returns in two ways: one, they earn interest income on the securities they hold. Secondly, since they invest in lower-rated securities, if the rating of a security is upgraded, they make gains. The credit risk funds thus give high returns if the calls on the low-rated papers go right. However, the opposite scenario is also possible.

There is a huge liquidity risk involved in these schemes. If a bond with a lower rating in the portfolio defaults or faces a downgrade, it may be difficult for the fund manager to exit the investment. “I think these schemes have a huge risk attached to them. Informed investors who want to time their exits can earn good returns. But retail investors who have a small portfolio should not take such risk. In simple terms, investors can lose their capital in case of a default. By this, I don’t mean that your investment will become zero, but there might be depletion in years of accumulated returns,” says Deepali Sen, Founder, Srujan Financial Advisors.

To mitigate risk, financial planners advise investors to choose large-sized funds in this category. Concentration to one bad investment can lead to more damage in case of a default. It is better to choose a scheme with a large, diversified portfolio to avoid concentration risk. “Those who want to bet on these schemes should choose a good scheme, preferably having a good asset base and a diversified portfolio. Those who cannot time the market, cannot take tactical calls or have a conservative investment approach can skip this category of funds,” advises Deepali Sen.

Returns from these schemes within three years of investment are subject to short-term capital gains tax as per your income-tax slab. Once you complete three years in the scheme, you are eligible for long-term capital gains tax of 20 per cent with indexation benefit. There is no tax on the dividends that you get from your investment in these schemes, but the scheme has to pay a dividend-distribution tax of 28.84 per cent.
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