Credit Risk Fund

A credit risk fund is a debt mutual fund that deliberately lends to lower-rated borrowers to chase higher returns. Under SEBI's classification, it must hold at least 65% of assets in corporate bonds rated AA and below, the riskier end of the credit spectrum.

How it works

Higher-rated AAA bonds pay modest yields because default is unlikely. Lower-rated issuers must offer fatter coupons to attract lenders. A credit risk fund earns this extra yield, the credit spread, by accepting the chance that some borrowers stumble or default.

The fund manager's job is credit selection: picking issuers likely to be upgraded or to repay reliably, while diversifying across many names so one default does not sink the portfolio. When a held bond gets upgraded, the fund can also book capital gains as its price rises.

In India

These funds carry a difficult reputation in India. The 2018 IL&FS crisis and the later DHFL and Franklin Templeton episodes showed how quickly lower-rated debt can turn illiquid and how badly investors can be hurt when bonds are written down or trading freezes.

Taxation no longer favours them either. Since the rules changed in April 2023, gains on debt funds, including credit risk funds, are added to your income and taxed at your slab rate regardless of holding period, with the indexation benefit gone. That removes much of the old long-term tax advantage.

Why it matters

Credit risk funds can outperform safer debt funds in calm markets, but they concentrate exactly the risk most conservative investors are trying to avoid. They suit only those who understand credit and can stomach volatility.

Common mistakes

The biggest error is treating a credit risk fund like a safe fixed-deposit substitute because it shows a tempting yield. That yield is compensation for default risk, not free money. Chasing the highest-yielding fund without checking portfolio quality and concentration is how investors got burned in past blow-ups.