Credit is a measure to assure if the borrower is worth credit or not.
Before giving credit lender calculates all the possibilities if the borrower is able to pay back.
The lender checks if he is able to recover all of the principal and interest from the borrower.
Credit risk is a risk that the borrower may not repay back the principal on time.
This is the reason why banks always ask for collateral while giving a loan.
In case the individual defaults, banks can cease the collateral and extract money from it by liquidating them.
In short credit risk is the risk of default on the debt that may be caused by borrower if borrower fails to make required payments.
Sometimes the lender can lost principal and interest the risk lays in it.
To avoid credit risk the lender mostly performs a credit check on the borrower before giving him credit.
Borrower gives some kind of guarantee from a third party or with some of his material property.
Sometimes lender takes out insurance against credit risk.
In simple words credit risk arises when the borrower is unable to pay due willingly or unwillingly.
Credit Risk in Debt and Equity mutual funds
Risk is intrinsic to investing. Investments vary across the risk range.
There isn’t any investment that’s totally risk-free. Mutual funds also contain risk.
Risk is the other name for volatility or variation in price in the world of investments.
An investment that is impressionable to wild swings in either direction is reviewed to be highly risky.
Both equity funds and debt funds carry risk.
Debt funds are generally not as risky as equity funds.
Equity tends to be volatile, especially in the short to medium term.
Debt funds essentially are mutual funds those who invests in Debt securities like Govt.
Bonds or securities, Corporate bonds and other debt instruments.
In simple words a debt fund is a Mutual Fund scheme that invests in fixed income instruments, like Government and Corporate Bonds, money market instruments and corporate debt securities etc. that offer capital appreciation.
Investors who aim for regular income, debt funds are ideal for, but aren’t risk free.
Debt funds are less volatile so they are less risky than equity funds.
How credit risk is important in debt mutual fund?
In debt mutual fund credit risk refers to the risk that the borrower may default in paying the coupons or principal.
High credit rating mutual funds have less chance to be default compared to the low credit rating mutual funds.
The assign of credit ratings may change over the time depending on many factors.
Default in payment of principal amount by the bond issuer results in credit risk.
Investor can find out which bond has higher credit risk and which bond has lower credit risk by looking at its rating by the credit rating agencies. The higher credit rating of a bond shows low risk. Generally government securities have a high credit rating in comparison to the corporate bonds.
A debt mutual fund usually invests the corpus in a diversified portfolio of securities.
Investor should check the credit rating of the securities in the portfolio before investing in a debt mutual fund.
If a credit rating agency lowers a particular bond’s rating to reflect more risk, the bond’s yield will increase and its price drop.
While investing a debt mutual fund, it is always wise to check the quality of its portfolio investment and the credit rating of such investments.
Always invest in a fund with a stable portfolio and a highly proficient AMC.
It is the risk of default when borrower fails to make required payments.
A default in a portfolio may impact the fund. A corporate bond with an AAA rating is considered of the highest quality.
Investors should be careful on the papers which the scheme invests in. Some schemes may invest in low-rated papers to generate better returns. So a conservative investor can avoid investment in such schemes.
So, now we know it isn’t correct to assume Debt Mutual Funds are as safe as bank fixed deposits.
This is the risk that the bond issuer might default on coupon and/or principal repayments.
People use ‘Credit Ratings’ to measure the creditworthiness of companies (or individuals).
If the credit rating of the company is high, the quality of the bond issued by it is always high.
So, the coupon rates of bonds issued by companies having high credit rating are low.
The bonds issued by companies having low credit ratings are high coupon rates.
The assigned credit ratings change over time so investor must monitor them continually to make an assessment of the credit worthiness of the entity in question.
What are credit-risk funds?
The debt funds which have at least 65% of their investments in less than AA-rated paper are Credit-risk funds.
They generate high returns by taking higher credit risk and by investing in lower-rated papers.
Credit risk funds offer higher interest rates and when their ratings move up, they offer a benefit of capital gains.
Most of credit risk funds have a lower duration so the interest risk in such funds is low.
These funds usually have the potential to give 2-3% higher returns in comparing with risk-free papers.