Credit Risk Fund
A credit risk fund is a debt mutual fund that invested at least 65 percent of its corpus in corporate bonds rated below the highest credit quality (AA+ and above), seeking higher yields by accepting elevated default and downgrade risk.
Credit risk funds occupied the riskiest end of the debt mutual fund spectrum, deliberately investing in corporate bonds that offered above-market yields precisely because the market priced a higher probability of default or downgrade into their prices. SEBI's 2017 categorisation circular codified the category, requiring at least 65 percent allocation to instruments rated AA and below. This distinguished credit risk funds from corporate bond funds (minimum 80 percent AA+ and above) and banking & PSU funds (minimum 80 percent in bank and PSU debt).
The yield premium offered by lower-rated bonds — the credit spread — was the source of return in a credit risk fund. In favourable credit environments, when the Indian economy was growing, corporate cash flows were healthy, and default rates were low, credit risk funds delivered meaningfully higher returns than equivalent-duration gilt or corporate bond funds. This attracted investors during benign credit cycles, as the enhanced yield appeared to offer a superior return without proportionate risk.
The credit cycle downturn of 2018–2020 delivered a sharp lesson to the Indian mutual fund industry and its investors. The IL&FS default in September 2018 triggered a cascade of downgrades and payment failures across NBFC and infrastructure companies. Credit risk funds holding paper from Dewan Housing Finance (DHFL), Altico Capital, Essel Group, Zee Enterprises, and other stressed entities suffered severe NAV erosion. Some funds were unable to meet redemptions, leading SEBI to introduce a new regulatory tool: side-pocketing, which allowed funds to segregate stressed assets from the main portfolio to prevent distressed liquidation of sound holdings.
Side-pocketing (formal name: segregated portfolio) was introduced by SEBI in December 2018 in direct response to credit events. When a debt instrument in a fund's portfolio was downgraded to below investment grade or defaulted, the AMC could create a separate segregated portfolio for that holding, giving existing investors units in both the main and segregated portfolios. The segregated portfolio units could only be redeemed if and when recovery was made, providing fairness to both exiting and continuing investors.
Post the IL&FS episode, investor interest in credit risk funds declined sharply and many AMCs restructured or merged credit risk schemes. For investors, these funds required careful evaluation of the portfolio's underlying holdings, credit concentration, the AMC's credit research capabilities, and current credit spreads relative to historical averages before allocation.