Credit risk funds are debt-oriented schemes that invest mainly in lower-rated corporate bonds. Under SEBI’s rules, they must invest at least 65% of their total assets in corporate bonds rated AA or below, excluding AA+.

Credit ratings give you an idea of how likely a company is to repay its debt. AAA is a higher credit rating, while AA, A and BBB-rated bonds carry progressively more credit risk.

So, why would anyone invest in a lower-rated bond? The answer is higher return potential. Companies with lower credit ratings generally need to offer higher interest rates to attract lenders. A credit risk debt fund tries to earn from these high interest payments.

But there is a trade-off. If a company struggles to repay its debt, the bond's value can fall. This makes credit risk schemes riskier than other schemes such as corporate bond funds, banking PSU funds or gilt funds. They are also very different from equity funds, where risk comes from changes in stock prices.

Credit risk funds may suit you if:

• You want higher returns from debt funds: If you are comfortable taking more credit risk in exchange for potentially higher returns, you can consider this category.
• You can stay invested for the long term: Credit events can affect a fund’s NAV suddenly. If you can give your investment more time, it can make it easier to deal with short-term volatility.
• You understand the risks involved: Many people assume that debt funds cannot fall. But that is not true. If you can handle the debt market risks like rating downgrades or default risks, then these schemes may be for you.
• You want to add some credit exposure to your portfolio: If you have invested in large-cap funds or Nifty 50 funds, you can allocate some portion to a credit risk fund for different exposure.

When you invest in a credit risk mutual fund, your money is pooled with that of other investors. The fund manager then invests that money across corporate bonds and other permitted instruments.

The fund can earn returns in two ways:

• Interest income: The companies issuing bonds pay interest to the fund.
• Change in bond prices: If a company’s financial position improves, its credit rating may be upgraded. This may increase its bond value.

So, how does this benefit you as an investor? When the fund receives interest from underlying bonds, the fund’s NAV rises. When the credit rating improves and bond prices increase, this also pushes up the NAV.

But suppose one company runs into financial trouble. Its bond may be downgraded, causing its market value to fall. The fund’s NAV can also fall. So, unlike a bank FD, your return is not fixed.

Investing in credit risk mutual funds can give you these benefits:

• Higher return potential: Lower-rated corporate bonds generally offer higher interest rates as investors are taking more credit risk.
• Opportunity to benefit from rating upgrades: If a company’s credit rating improves, it can increase the market value of its bonds and potentially benefit the fund.
• Professional credit research: The fund manager assesses the issuers and decides which securities fit the fund’s strategy. You don’t have to individually analyse every company yourself.
• Diversification across multiple bond issuers: These schemes generally invest across multiple debt securities rather than lending all their money to one company. This can reduce the impact of one issuer’s default.

Here are key risks to consider before investing in these schemes:

• Default risk: If a company cannot pay interest or repay its debt, the value of the bond can fall sharply.
• Credit downgrade risk: If the company’s financial position worsens and its credit rating is downgraded, mutual fund investors may value its bonds at a lower price. This can reduce the fund’s NAV.
• Liquidity risk: Lower-rated corporate bonds may not be as easy to sell as highly traded government securities. During stressed market conditions, selling such bonds can become difficult or may be done at a lower price.
• Interest rate risk: Credit risk schemes are debt funds, so any changes in interest rates can affect their bond prices. The impact depends on the maturity and duration of the fund’s portfolio.
• Concentration risk: If a fund has significant exposure to a particular company or sector, problems in that industry can have a bigger impact on the portfolio.

How can you handle these risks?

Though you cannot completely eliminate all the risks, here are some steps you can take to manage them wisely:

• Give it enough time: Consider investing in these schemes if you have a time horizon of 3 to 5 years. Giving enough time helps with periods of volatility.
• Diversify: Don’t invest all your money in credit risk schemes. You can pair them with other schemes like flexi-cap funds or balanced hybrid funds.
• Don’t invest emergency money: Keep emergency money somewhere more accessible. You can consider lower-risk options such as overnight funds or liquid funds.

While all these schemes invest in debt securities, the type of risk they take can be quite different. Let’s compare:

If you are more concerned about interest-rate movements than the credit quality, you can also explore floater funds, short duration funds or medium duration funds, depending on your investment horizon.

If you want to pick the best credit risk mutual funds, then don’t simply pick the one with the highest recent return. Instead, check:

• Credit quality: Look at the ratings of the bonds in the portfolio. Understand how much the fund has invested in AA, A and lower-rated securities.
• Portfolio concentration: Check the fund’s exposure to the individual companies and sectors.
• YTM and duration: A yield-to-maturity (YTM) is a percentage that tells you how much return you can expect from the bond if held till maturity. Higher YTM offers higher returns, but they also come with higher risks.
• Expense ratio: A lower expense ratio can help you keep more of the fund’s returns. Prefer direct plans over regular plans to save costs.
• Fund manager and investment process: Look at how the fund manager handles credit risk and how the portfolio has behaved during periods of market stress.

While picking the right credit risk funds to invest in, don’t just choose based on higher YTM. Always consider your risk tolerance and time horizon before investing.

Once you pick the fund that suits your risk profile and investment horizon, setting up an automated SIP on Millions takes only a few minutes:

• Install the Millions app from the Google Play Store or the iOS App Store.
• Enter your mobile number, verify your identity and complete the KYC process.
• Log in and head over to the mutual funds section to filter credit risk funds and compare the schemes.
• Once you select the fund, tap on ‘SIP’ and choose your preferred frequency from daily, weekly or monthly.
• Enter the amount you’d like to invest, pick the recurring investment date and authorise the initial payment.

That’s it. Your investment plan is set! While credit risk schemes offer higher returns, you should not put all your savings into one type of fund. For a more growth-focused portfolio, you can pair them with multi-cap funds or large-cap funds. If you prefer having a better overall balance, then you can also consider arbitrage funds or equity savings funds.