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 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.
"Credit-risk funds have benefited from a favourable credit cycle over the past three years," Meshram said.
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 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.
