Corporate Bond vs Credit Risk Funds: Making a Choice
A corporate bond fund lends your money mainly to India’s strongest borrowers and accepts a lower yield for that safety. A credit risk fund deliberately lends to weaker borrowers, charges them more, and so starts with a higher yield and a real chance of losing capital if one borrower stops paying.
Credit risk is the risk that a bond issuer fails to pay interest or principal on time, or gets downgraded so sharply that the bond’s market value falls before any default happens. Both categories sit in the same slot of a portfolio. The extra return in one is paid for out of the other’s safety margin.
What follows: the arithmetic of extra yield against a single default, how tax changed after April 2023, and a checklist for finding out what you actually own.
The credit ladder, and the two categories side by side
Rating agencies grade Indian debt from AAA down through AA, A, BBB and lower. Yield rises as you step down that ladder because lenders demand compensation for a shakier borrower. That is the entire economics of these two categories.
SEBI’s categorisation rules keep each fund in its lane. A corporate bond fund holds the bulk of assets in the highest rated corporate paper; a credit risk fund holds the bulk in paper rated below that top notch. The exact percentage sits in the scheme information document.
| Feature | Corporate bond fund | Credit risk fund |
|---|---|---|
| Core holding | Highest rated corporate bonds | Bonds rated below the highest grade |
| Main return driver | Interest income plus rate movement | Higher coupons plus rating upgrades |
| Biggest threat | Rates rising, pushing bond prices down | One issuer defaulting or being downgraded |
| Portfolio spread | Wide, often 40 or more issuers | Narrower, so each name carries more weight |
| Liquidity of holdings | Generally traded and sellable | Thin, and can seize up under stress |
| Expense ratio and exit load | Lower, load often nil | Higher, load often six months to a year |
| Suits | A 3 year plus home for goal-linked money | A small satellite slice you can watch fall |
The liquidity row causes more damage than the default row. When redemptions spike, a fund holding thinly traded paper either sells the good bonds first, worsening what remains, or restricts redemptions.
Worked example: is the extra yield worth it?
Put Rs 5,00,000 into each fund.
Fund A, a corporate bond fund, has a portfolio yield to maturity of 7.4% and a direct plan expense ratio of 0.35%. Net of cost, about 7.05%, so roughly Rs 35,250 for the year.
Fund B, a credit risk fund, has a YTM of 9.2% and an expense ratio of 0.85%. Net of cost, about 8.35%, so roughly Rs 41,750.
Extra income for taking credit risk: Rs 41,750 minus Rs 35,250 equals Rs 6,500 a year, or 1.3 percentage points. On a factsheet it looks free.
Now price the downside. Say one issuer at 5% of assets defaults and is written down to zero. NAV falls 5% immediately, so Rs 25,000 of your Rs 5,00,000 is gone.
Rs 25,000 divided by Rs 6,500 is about 3.8. One default at a 5% weight erases nearly four years of the extra yield, and a 5% write-down is a mild outcome. Several Indian credit funds lost considerably more in 2018 and 2019, when write-downs arrived in clusters.
That is the real trade: a steady small gain against an occasional large loss.
Why do credit risk funds get into trouble together?
Because the same weak issuers sit in many portfolios. When a large finance company defaults, every fund holding its paper marks it down the same week.
- Side pocketing. SEBI allows a fund to segregate distressed paper so exiting investors cannot dump the loss on those who stay. Useful, but part of your money is then locked until recovery.
- Downgrade before default. A move from AA to A knocks the bond’s price down well before any missed payment, so NAV drops on news alone.
- Concentration. Fewer issuers means each name matters more. The riskometer and risk rating is a starting point, though the monthly portfolio tells you much more.
How is the tax treated now?
Units of debt mutual funds bought on or after 1 April 2023 are specified mutual funds under Section 50AA. Gains are taxed at your income tax slab rate however long you hold, with no indexation and no separate long term rate.
At a 30% slab, Fund B’s Rs 41,750 becomes roughly Rs 29,225 after tax and Fund A’s Rs 35,250 becomes about Rs 24,675, so the yield advantage shrinks from Rs 6,500 to about Rs 4,550.
Both categories are hit equally, so the rule favours neither. It does weaken the case for taking credit risk purely to beat a fixed deposit. Read how mutual fund returns are taxed before committing.
How do you check what you are really holding?
Category names mislead. A conservative sounding fund can hold surprising paper.
- Download the latest monthly portfolio disclosure from the AMC site. Not the factsheet summary, the full holdings list.
- Sort by weight and read the top ten issuers. Any single non-government issuer above roughly 5% is a concentration you are accepting.
- Add up everything rated AA and below. That total, not the fund’s name, is your credit exposure.
- Look for group exposure. Three companies from one business group are one risk wearing three names.
- Note average maturity and modified duration. High credit risk with long duration is two bets at once.
If that inspection sounds like a chore you will not repeat monthly, that is a signal a credit risk fund is not for you.
So which one should you pick?
For most retail investors with a 3 to 5 year horizon and a goal attached to the money, the corporate bond fund is the sensible default. The debt part of a portfolio exists for stability, and 1.3 percentage points is not worth a loss that can arrive without warning.
A credit risk fund can make sense if you already hold a stable core, can leave the money untouched for four years, are comfortable with a temporary double digit fall, and will read the monthly portfolio. Keep it small. If you need the money within a year, neither fits: short horizons belong in a liquid fund, where credit and duration risk are both minimal.
Frequently Asked Questions
Can a credit risk fund’s NAV go to zero?
No. NAV cannot go negative because the fund’s liability is limited to its assets. It can fall very sharply though, and side pocketed portions may end up worth almost nothing. Indian episodes have included falls of well over 20% within a few weeks for the worst affected schemes.
Is a corporate bond fund safer than a bank fixed deposit?
No. A deposit carries insurance up to a stated limit and pays a contracted rate. A corporate bond fund has no capital protection and its NAV falls when rates rise. It can beat a deposit over a full cycle, and it can also hand you a negative six month stretch, which a deposit will not.
How long should I hold each type?
Match the holding period roughly to the portfolio’s duration so rate swings have time to even out. For corporate bond funds that usually means 3 years or more. For credit risk funds, plan on 4 years or longer, so higher coupons can compensate for any accident and the exit load stops applying.
What happens to my money if the fund is wound up?
Trustees sell the portfolio and return proceeds in instalments as bonds mature or find buyers. With low rated illiquid paper this can stretch over years, and you receive whatever the assets realise. That is why the liquidity of the underlying bonds matters more than the headline yield.
Can I run a SIP into these funds?
Yes, and for corporate bond funds it spreads entry across interest rate cycles nicely. For credit risk funds a SIP does not reduce the core hazard, since a default hits every unit you own regardless of when you bought it. Averaging helps with price volatility, not credit events.
Key Takeaways
- Corporate bond funds hold mostly top rated paper; credit risk funds hold mostly lower rated paper by design, and SEBI’s category rules force that split.
- The typical yield gap is roughly 1 to 2 percentage points, and one default at a 5% portfolio weight can wipe out close to four years of that gap.
- Illiquidity of low rated bonds does more damage during redemption pressure than the default itself, because the fund cannot sell at fair value.
- Debt fund units bought on or after 1 April 2023 are taxed at your slab rate with no indexation, trimming the after tax reward for credit risk.
- Judge a fund by its monthly portfolio: issuer concentration, group exposure and the share rated AA or below, never by its category name.
