Credit-risk funds have emerged as the best-performing debt mutual fund category over the past three years, delivering 8.97% returns. The category has benefited from improving corporate balance sheets, lower leverage, better profitability and easing concerns around defaults.
The strong performance, however, comes with a higher level of risk. Credit-risk funds invest in lower-rated corporate bonds to generate higher yields, exposing investors to the possibility of downgrades, defaults and liquidity stress.
For investors considering the category after its recent performance, experts say the key is to look beyond returns and understand how those returns were generated.
Credit-risk funds ride stronger corporate balance sheets to 8.97% returns
Credit-risk funds benefited from a favourable credit cycle over the past three years, said Nehal Meshram, senior research analyst at Morningstar Research India.
Corporate balance sheets strengthened, leverage declined and profitability improved, while concerns around defaults moderated. This resulted in narrowing credit spreads, which generated capital gains for funds holding lower-rated bonds.
The category also continued to earn relatively high accrual income because of its exposure to AA and below-rated securities. This combination of higher carry and gains from spread compression helped boost returns.
Nirav Karkera, head of research and fund manager at W by Groww, said the category’s three-year performance was driven by three factors. These were the credit spread earned on lower-rated securities, duration gains during the interest-rate easing cycle and the absence of major defaults or downgrades.
According to Karkera, credit-risk fund portfolios have an average exposure of around 55-59% to AA-rated bonds and a yield to maturity of roughly 8-8.4%. The spread between this yield and the repo rate widened from around 1.6% in mid-2023 to approximately 2.8% currently, keeping accrual income attractive.
Duration also contributed to returns. Average modified duration was around 2.3 years in late 2024, according to Karkera, when the category entered the interest-rate easing cycle. The Reserve Bank of India cut the repo rate by 125 basis points through 2025, allowing funds to benefit from mark-to-market gains on bonds.
At the same time, the credit environment remained relatively benign, with no major default or downgrade hurting the category, Karkera said.
The extra yield comes with higher credit and liquidity risk
The 8.97% three-year return should not be interpreted as a comparable return from a low-risk debt investment.
Credit-risk funds are required to invest at least 65% of their portfolio in corporate bonds rated AA and below. The strategy is therefore explicitly designed to take additional credit risk in return for potentially higher yields.
By comparison, corporate bond and banking & PSU funds generally have greater exposure to higher-quality issuers, while short-duration funds have tighter duration parameters.
Karkera said the category’s yield to maturity is currently around 8.1%, roughly 60-120 basis points above a clean banking & PSU or corporate bond fund. However, investors need to weigh this additional yield against the higher credit and liquidity risks.
“With spreads this compressed, the extra yield is thin relative to the risk,” he said.
Credit-risk funds can also experience sharper NAV movements when an issuer is downgraded or defaults. Investors therefore need to be prepared for occasional volatility even though the underlying investments are debt securities.
Meshram said the category is better suited to investors with a higher risk appetite and a holding period of at least three to five years. Such funds can form a satellite allocation within a diversified debt portfolio.
Conservative investors, retirees seeking capital stability and those investing for short-term financial needs should generally avoid the category.
Karkera also cautioned against using credit-risk funds for emergency or near-term money. The experience of 2020 showed that liquidity can dry up when investors most want to exit.
“If the money can’t afford to fall in value, avoid,” he said.
Experts flag concentration and lower-rated exposure as key risks
The recent three-year performance makes it particularly important for investors to examine the underlying portfolio rather than simply selecting the fund with the highest return.
Meshram said investors should assess a fund’s credit quality, issuer concentration, sector exposure and liquidity profile. A fund generating higher returns through excessive exposure to lower-rated issuers or a handful of companies could carry significantly greater risk.
Karkera said the same category label can hide substantial differences in portfolio risk. A-and-below exposure across credit-risk funds ranges from around 0.5% in some of the more conservative funds to nearly 18% in the most aggressive ones.
Investors should therefore track how much of a fund’s portfolio is invested in A-and-below-rated securities and whether that exposure is rising.
An unusually high YTM compared with peers is another warning sign, particularly when funds have similar duration. A higher yield can indicate that the fund is taking additional credit risk rather than simply managing its portfolio better.
Investors should also watch for heavy single-issuer or group concentration, large allocations to illiquid securities, exposure to stressed sectors and sudden extensions in portfolio maturity to chase returns.
A shrinking assets under management base can also create problems if the fund is forced to sell illiquid bonds during periods of heavy redemptions.
For investors, the recent 8.97% three-year return should not be the sole reason to enter credit-risk funds. Karkera said the category’s current yield premium over safer debt funds needs to be weighed against the additional credit and liquidity risk, particularly as spreads have already compressed.
Meshram said investors with a higher risk appetite and a three-to-five-year horizon may consider credit-risk funds as a satellite allocation within a diversified debt portfolio. For conservative investors, retirees seeking capital stability and those with short-term goals, the category may not be appropriate.