What are credit-risk funds?

Credit-risk funds are debt funds which have at least 65% of their investments in less than AA rated paper. They generate high returns by taking higher credit risk and by investing in lower-rated papers. Such companies offer higher interest rates and as and when their ratings move up, they offer a benefit of capital gains. The interest risk in these funds is low as most of them have a lower duration. These funds typically have the potential to give 2-3% higher returns compared to risk-free papers.

How do the funds work?

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 have the potential to make capital gains.

What is the tax treatment of these funds?

Dividends are exempt from tax, but the scheme has to pay a dividend-distribution tax of 28.84%. Returns you earn within three years of investment are subject to short-term capital gains tax. This will be as per your income-tax slab. After three years, you are eligible for long term capital gains tax at 20% with the benefit of indexation.

How should investors choose a credit-risk fund?

Credit-risk funds have a higher liquidity risk. If a bond with a lower rating in the portfolio defaults or faces a further downgrade, it may be difficult for the fund manager to exit this holding.

Financial planners advise investors to choose large-sized funds in this category. Higher assets give the fund manager better scope to diversify and spread risks. Investors should also look at a fund with a lower expense ratio and make sure the portfolio is not concentrated or has high holdings in any single business group. They should choose a fund manager and a fund house with good experience in managing debt portfolios. Finally, investors should not hold more than 20% of their debt portfolios in such funds, which typically carry higher risk compared to other debt funds.