Credit risk fund

Every bond carries the risk that the issuer fails to pay interest or principal on time. That is credit risk. The workbook notes that corporate bonds carry more of it than government securities, and that among corporate bonds AAA-rated bonds are comparatively less risky than AA-rated ones.

Most debt fund categories try to limit credit risk. A credit risk fund deliberately takes it. SEBI defines it as an open-ended debt scheme investing in below highest rated corporate bonds, with at least 65 per cent of total assets in corporate bonds rated AA and below — and AA+ is excluded, so AA+ paper does not count towards the 65 per cent.

The idea is that lower-rated issuers must pay higher interest to borrow, so a portfolio of them can earn more than a portfolio of top-rated bonds. The price is a higher chance that some issuer is downgraded or defaults — and when that happens, the bond's price falls and the NAV with it.

The category is defined by credit rating, which is why credit rating agencies matter so much to it.

The two corporate debt categories side by side, from SEBI's scheme categorisation:

The naming rule. A footnote to the credit risk fund definition records SEBI's instruction (circular of 6 October 2017) that words or phrases highlighting only the return aspect of a scheme may not be used in its name — the workbook's examples are "credit opportunities fund", "high yield fund" and "credit advantage". The category is named for its risk, not its reward.

How credit risk is described and managed (Chapter 7):

• Credit risk is an issuer's inability to meet interest and principal payments.
• Different securities in the SID carry different levels of credit risk, so a scheme's risk rises or falls with its investment pattern.
• The investment manager manages it through in-house credit analysis — detailed analysis and due diligence, issuer limits on amount and maximum tenor (excluding the Government of India), and initial and periodic review of each issuer's financial and operational strength.
• Fund managers use credit ratings as an initial input, before their own due diligence (Chapter 3).
• A downgrade from AAA to AA+ hurts a security's price, and an upgrade helps it — the rating migration risk Chapter 7 describes.

Distribution. The new cadre of distributors may sell only simple and performing schemes — liquid/money market, index, diversified equity, tax-benefit retirement schemes and FMPs. Credit risk schemes are not on that list; Chapter 4's sample question offers them as a wrong answer.

Compare two debt funds, each Rs 1,000 crore. The portfolios and yields are illustrative; the category thresholds are the workbook's.

On a Rs 5,00,000 holding, the extra 1.5 percentage points is about Rs 7,500 a year — if nothing goes wrong.

Now one AA-rated issuer, making up 5 per cent of the credit risk fund, is downgraded and its bonds are marked down 50 per cent.

Loss on that holding = 5% × 50% = 2.5% of NAV
On Rs 5,00,000       = Rs 12,500

That single event wipes out well over a year's extra income. And if an AA+ bond were in the credit risk fund, it would not count towards the 65 per cent — the manager could not reach the category minimum by loading up on AA+ paper.

The category label is the warning. That is why SEBI will not let such a fund call itself a "high yield" or "credit opportunities" fund.

Chapter 2 (Concept and Role of a Mutual Fund), section 2.2, defines Credit Risk Fund and Corporate Bond Fund in SEBI's debt sub-categories, with the naming footnote; Chapter 3 notes that these categories are defined by credit rating; Chapter 7 covers credit risk and its management; Chapter 4 excludes credit risk schemes from the new cadre's product list. Expect the 65 per cent / AA-and-below definition, the AA+ exclusion, the contrast with corporate bond funds (80 per cent, AA+ and above), and the new cadre question.

• Credit risk fund: 65% in AA and below — AA+ excluded. Corporate bond fund: 80% in AA+ and above.
• "Below highest rated" does not mean unrated or junk only — AA-rated bonds qualify.
• Names emphasising only returns are banned — no "high yield", "credit opportunities" or "credit advantage".
• Higher yield is compensation for higher default and downgrade risk, not a free extra return.
• Not a product for the new cadre of distributors — they sell only simple and performing schemes.
• AAA bonds are comparatively less risky than AA bonds, and corporate bonds carry more credit risk than government securities.
• Credit ratings are an initial input; fund managers still do their own due diligence.