Investing in credit risk funds is risky

K. ARAVIND

Credit risk funds are a group of debt funds that invest in bonds. These are called credit risk funds because they are invested in high risk bonds.

About 65% of such funds invest in bonds below AA rating. According to SEBI’s classification, the rating of superior loan schemes should be AA + or above. Bonds below the AA rating are at higher risk. The higher the risk, the higher the return! As their ratings rise, so does their capital gains. Therefore, credit risk funds are more likely to give higher returns than liquid funds.

Credit risk funds are only suitable for high risk investors. Lower rating is a risk factor. Bonds are rated by agencies based on their credit rating.

There are two types of returns on such funds. The interest earned on the bonds in which they are deposited is a kind of gain. Demand for this specialty has grown significantly as a result of recent corporate scandals.

The increase in the price of bonds will also be reflected in the NAV of the funds as demand increases. There is also the potential for capital gains. In the long run, credit risk funds are likely to offer two per cent more annual returns than liquid funds.

Short-term capital gains tax is applicable on gains made from credit risk funds within three years. The investor’s income tax is taxable according to the slab rate. That is, the tax should be calculated along with the investor’s annual income. Long-term capital gains tax is applicable on gains made after three years.

If the investment is withdrawn after three years, 20 per cent of the amount received is taxable in excess of the current value calculated under the Cost Inflation Index of the previous investment. Dividends are not taxable. But the schemes pay 28.84 per cent dividend distribution tax.

Such funds are not suitable for ordinary investors because the risk is high. Failure to repay any debentures may adversely affect the NAV.

Liquid funds are ideal for ordinary investors. Liquid funds can expect a return equal to the repo rate on an annual basis, but many funds are able to provide better annual returns than the repo rate due to the excellence of fund management.