Credit risk mutual fund

A credit risk mutual fund in India is an open-ended debt scheme that must invest a minimum of 65% of its total assets in below-AA-rated corporate bonds (specifically AA-rated and below, including A, BBB, and sub-investment-grade instruments), under SEBI’s October 2017 scheme categorisation circular. These funds aim to generate higher yields than investment-grade debt funds by taking on credit risk – the risk that the issuing company may default on interest payments or principal repayment. Credit risk funds are the highest-risk category within the debt mutual fund universe and have faced significant investor confidence issues following a series of credit events in 2019 to 2020.

Regulatory definition

SEBI circular SEBI/HO/IMD/DF3/CIR/P/2017/114 defined credit risk funds as:

• Scheme type: Open-ended debt scheme investing in below AA-rated instruments.
• Minimum allocation: At least 65% of total assets in below-AA-rated corporate bonds (AA and lower).
• Duration constraint: None.
• Benchmark: Typically CRISIL Credit Risk Index or NIFTY Credit Risk Bond Index.

The “below AA” classification in India includes AA, A1+, A, A-, BBB+, BBB, and sub-investment-grade paper from a spectrum of corporate issuers.

Investment strategy

Credit risk funds follow an accrual strategy: rather than trading bonds for capital gains (as in gilt funds), they hold bonds to maturity (or near maturity), collecting coupon interest. The higher coupon on below-AA bonds is the primary return driver.

The yield advantage of below-AA bonds over AAA government securities in India has historically been 150 to 400 basis points (1.5% to 4%), varying with the credit cycle. In benign credit environments (2012 to 2017), credit risk funds generated 9% to 11% annualised returns, well above liquid funds or corporate bond funds.

Credit events and the 2019-2020 crisis

The credit risk fund category in India suffered severe reputational and performance damage following a series of credit events:

IL&FS default (2018): Infrastructure Leasing and Financial Services (IL&FS), a AAA-rated infrastructure holding company, defaulted on its debt obligations in September 2018. Several debt funds (including some credit risk funds) holding IL&FS paper took significant NAV markdowns.

DHFL default (2019): Dewan Housing Finance Corporation Limited (DHFL), a large housing finance company, defaulted on its bond obligations. Many credit risk funds had significant DHFL exposure.

Yes Bank AT1 bonds (2020): Yes Bank’s Additional Tier 1 (AT1) bonds were written down to zero as part of the RBI-administered bailout, causing sharp NAV declines for funds holding these instruments.

Franklin Templeton fund winding-up (April 2020): In April 2020, Franklin Templeton Mutual Fund wound up six of its fixed-income schemes (including its credit risk fund) due to severe liquidity stress caused by a combination of credit events, COVID-19 market disruption, and large redemption pressure. Investors were locked out for over two years while the fund manager liquidated the portfolio. This was the most significant fund-level crisis in Indian mutual fund history and caused widespread investor anxiety about credit risk funds.

Side-pocketing

Following the IL&FS and DHFL defaults, SEBI introduced the side-pocketing mechanism (SEBI circular, January 2019). Side-pocketing allows debt mutual funds to segregate a defaulted or downgraded instrument into a separate “side pocket” portfolio:

• The main portfolio continues at the same NAV as before (excluding the distressed asset).
• A new side pocket portfolio unit is created, representing the investor’s proportional claim on the defaulted instrument.
• If the distressed asset recovers, the side pocket NAV rises and the recovery is passed to investors.
• Investors who redeem after side-pocketing receive full NAV on the main portfolio and retain their side-pocket units for future recovery.

Side-pocketing protects continuing investors from being harmed by outflows that force the fund to sell distressed assets at fire-sale prices.

Taxation

Credit risk funds are debt-oriented and taxed under the Finance Act 2023 framework.

For units purchased on or after 1 April 2023:

All gains are taxed at the investor’s slab rate regardless of holding period.

For units purchased before 1 April 2023:

• Less than 3 years: STCG at slab rate.
• 3 years or more: LTCG at 20% with indexation.

Securities Transaction Tax does not apply. See capital gains tax in India and ITR-2 for reporting. Notably, the abolition of LTCG-with-indexation (Finance Act 2023) further reduced the attractiveness of credit risk funds, as this benefit had been their primary tax differentiator for 3+ year investors.

Comparison with adjacent categories

Credit risk versus corporate bond fund

Corporate bond funds are restricted to AA+ and above paper, carrying minimal credit risk. Credit risk funds deliberately hold below-AA paper for higher yields, accepting materially higher default risk.

Credit risk versus medium-duration fund

Medium-duration funds mandate a 3-4 year Macaulay duration but can hold any credit quality. Many medium-duration funds mix AA+/AAA paper with some AA and below exposure for yield enhancement, without being classified as credit risk funds.

Credit risk versus dynamic bond fund

Dynamic bond funds can hold any mix of government and corporate securities with any duration. They may avoid credit risk entirely (by holding only gilts) or take credit risk; unlike credit risk funds, they do not have a mandated below-AA minimum.

Exemplar schemes

Credit risk funds with large AUM include:

• HDFC Credit Risk Debt Fund (HDFC Mutual Fund)
• ICICI Prudential Credit Risk Fund (ICICI Prudential Mutual Fund)
• Kotak Credit Risk Fund (Kotak Mahindra Mutual Fund)
• SBI Credit Risk Fund (SBI Mutual Fund)
• Aditya Birla Sun Life Credit Risk Fund (Aditya Birla Sun Life Mutual Fund)

These are cited for reference only. The category has seen significant AUM outflows since 2019 due to the credit events described above.

Suitability

Credit risk funds are suitable for:

• Sophisticated investors who understand credit analysis and credit cycles.
• Investors seeking yield enhancement beyond corporate bond funds, willing to accept higher default risk.
• Investors with a minimum 3-year horizon (to allow credit positions to mature and for the accrual strategy to work).
• Investors who can withstand significant short-term NAV shocks from credit events.

Credit risk funds are not suitable for:

• Conservative or moderate investors.
• Investors seeking capital safety.
• Investors with short horizons.
• Retail investors who cannot analyse credit quality of individual portfolio holdings.

Regulatory oversight

Credit risk funds are regulated by SEBI under the SEBI (Mutual Funds) Regulations, 1996. The mutual fund industry in India framework governs operations. SEBI has issued specific circulars on side-pocketing, stress testing, and credit risk disclosure requirements for debt mutual funds.

References

1. SEBI Circular SEBI/HO/IMD/DF3/CIR/P/2017/114, “Categorisation and Rationalisation of Mutual Fund Schemes”, 6 October 2017.
2. SEBI Circular SEBI/HO/IMD/DF3/CIR/P/2019/012, “Creation of Segregated Portfolio in Mutual Fund Schemes”, 28 January 2019.
3. Finance Act 2023, Section 50AA.
4. SEBI inquiry report on Franklin Templeton winding-up, 2021.
5. SEBI (Mutual Funds) Regulations, 1996, as amended.