All you need to know about credit risk

All kinds of investments entail some amount of risk. Credit risk, however, takes the center stage in fixed-income investment. One of the most popular debt instruments are the debt funds. Before investing in debt funds, you need to be aware of the manner in which you may entail credit risk.

What is Credit risk in Mutual Funds?

Debt funds make money by way of interest earned on the underlying assets i.e. debentures, bonds, treasury bills and the likes. Apart from that, the underlying security is obliged to repay the principal upon maturity. Debt funds are exposed to credit risk when a bond/debenture defaults on its interest/principal repayment obligations. So, in a way, investing in debt funds exposes you to credit risk indirectly.

Various rating agencies like CRISIL and ICRA assign credit ratings to debt securities which indicate their extent of creditworthiness. A higher rating indicates a lower probability of default by the issuer which issued the underlying security. These credit ratings are dynamic in nature. The ratings change as per the financial performance of the underlying security. In mutual funds, the fund manager looks at the credit rating of a security before investing in it. He/she may go for AAA-rated or below rated security as per the investment mandate of the fund. In debt funds arena, you may find funds which have no credit risk i.e. GILT funds to funds which have high credit risk.

How does credit risk affect fund NAV?

The Net Asset Value (NAV) of a debt fund is immensely affected by behavior of the underlying assets. Whenever a rating agency upgrades/downgrades the underlying security, it leads a change in the market price of the security. This leads to a change in the NAV of the debt fund. A rating downgrade on account of interest/principal repayment default usually decreases the market price of the security. This, in turn, reduces the fund NAV. Ultimately, returns on a debt fund are reflected in its NAV movement over a given time horizon. If a fund continues to experience a fall in the NAV, it means that the fund is losing money.

Debt securities which have low-credit ratings tend to give higher interest on investment. This is to compensate the investors for the undertaking high risk of investment. It is aligned to the principle that higher returns are associated with higher risk. Now, a fund manager would choose a security as per the fund’s objective. High return generating debt funds like credit opportunities fund, invest in high yield generating AA-rated or below rated securities. Conversely, other debt funds like GILT funds invest only in AAA-credit rated sovereign bonds which yield relatively moderate returns. In a nutshell, the debt fund manager tries to achieve optimal returns by managing risk.

How to manage credit risk while fund selection?

The amount of returns that you take home ultimately depends on your fund selection. While investing you need to ask yourself

What are my investment objectives?
What is my risk appetite?

As higher returns are associated with higher risk, you need to be clear about your risk-taking ability. Additionally, you need to prioritise wealth creation or safety of capital. If you expect higher returns from your debt fund portfolio, then you may allocate a portion to credit risk funds. But before that don’t forget to analyse its risk-adjusted returns generating ability. A look at Sharpe ratio of a debt fund, which can be found in fund’s factsheet, reflects its return potential. A credit risk fund which has a higher Sharpe ratio shows that the fund is generating enough extra returns to compensate for the high risk undertaken by way of low-credit rated securities. Conversely, if the safety of capital is your priority, then look for debt funds which invest in AAA-rated securities.