The core feature of a fixed income  instrument is such that they offer to pay a stated rate of interest periodically and return the principal at the end of a defined period. There are risks involved with such investments, especially the risk that the periodic repayment may not come in as promised. Investments in debt funds carry various types of risk such as  interest rate risk or inflation risk, etc. but the key risk which needs be considered before investing in debt funds is credit risk.

Credit risk is the risk that the issuer will not pay the coupon income and/or the maturity proceeds on the specified dates. This could also lead to capital erosion of the scheme's portfolio owing to a downgrade in the credit rating. The credit rating of a debt instrument indicates the credit risk that it carries. Credit rating is the measure of the credit worthiness, of the issuer to meet the interest and principal repayment obligation. A drop in the credit quality leads to a drop in liquidity.

Credit ratings are assigned by specified agencies like CRISIL, ICRA and other agencies based on multiple factors and assigned a symbol (See: Symbol and Definition below). These symbols indicate the degree of safety with respect to timely servicing of financial obligations from low to high credit. The portfolio of a debt fund scheme indicates the combined credit quality of its underlying holdings. For instance, investments in G-Secs carry no credit risk.

Investors need to note that the credit rating of an instrument may change over time, depending on improving or worsening financial strength of the issuer. So, if the credit rating of an instrument gets downgraded, its price will fall and if the rating is upgraded, its price will go up. The credit risk fund category adopts credit rating as a strategy to invest. These funds seek to maximise portfolio yield by primarily investing in below AA+ rated corporate bonds.

The premise being if the bond’s credit rating improves over time, it will make its price go up. Likewise, funds adopting the accrual strategy aim to generate returns by managing credit risk (to earn higher yield) while minimizing interest rate risk. Investing in a fund with a portfolio that invests in government securities, quasi-government securities such as PSU bonds, bank issuances and highly rated private sector companies of good parentage give the comfort of quality. A portfolio with high-quality papers is also easily liquidated when the need arises.

Credit rating is dynamic and can change over a period of time. Rating agencies evaluate the performance of companies and the risk assessment is done at periodic intervals. Investors should check the credit rating of underlying investments of a debt fund portfolio.

Symbol and Definition

("+" (plus) or "-"(minus) can be used with the rating symbols for the categories AA to C. The modifiers reflect the comparative standing within the category.