Credit risk funds are almost certainly something you’ve heard about or read about if you’ve been investing in debt mutual funds for a long time, either as a suggestion or something you might avoid, depending on who you were talking to. They offer returns that are 2-3% higher than those of safer debt funds, but they have also experienced some of the most significant drawdowns in the Indian mutual fund market. This article cuts through the hype and the fear to provide you with a good understanding of what a credit risk fund is, the risk-return tradeoff, and what to be aware of before investing.
What are Credit Risk Funds and How Do They Work?
A credit risk fund is a type of debt mutual fund recognized by the Securities and Exchange Board of India. According to SEBI regulations, credit risk funds must have at least 65% of their investments in corporate debt securities with an AA rating and below. This is the major difference from other less risky types of debt, such as PSU funds, banking funds, or corporate bond funds, which tend to hold almost exclusively AAA-rated bonds.
The idea is that bonds with lower ratings are more likely to go into default, which means that the bond issuer must provide a higher interest rate to appeal to investors. That additional yield is captured by the fund. If the underlying companies do well and their ratings improve, the funds enjoy a double boost: from a higher accrual income and also from the rise in the bond’s price based on the improved rating.
For example, think of it as lending money to a company that is not as well established as a large PSU, but in return gets a significantly high interest rate. When it’s done right, it’s effective. If managed poorly, or in an economic downturn, it can fall apart in a flash.
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The Return Potential of Credit Risk Funds
Over the 1-year period ending September 2025, the top-performing debt fund category was credit risk funds, which had an average category return of 10.5%. DSP (22.9%), HSBC (21.6%), and Aditya Birla Sun Life (17.1%) made outstanding returns during that time.
The category also had an average return of 9.30% in the year to March 2025, making it one of the best-performing debt categories in that time.
A snapshot of current fund-level performance (as of April 2026):
| Fund | 1-Year Return | 3-Year Return | 5-Year Return | AUM (approx.) |
| DSP Credit Risk Fund (Direct) | 11.4% | 16.8% | 13.1% | ₹223 Cr |
| HSBC Credit Risk Fund (Direct) | 17.8% | 11.7% | 9.3% | ₹476 Cr |
| Aditya Birla SL Credit Risk Fund (Direct) | 13% | 12.9% | 10.7% | ₹1,178 Cr |
| ICICI Prudential Credit Risk Fund (Direct) | 8.5% | 8.9% | 8% | ~₹6,000 Cr |
| Nippon India Credit Risk Fund (Direct) | 8.2% | 8.9% | 9.2% | ₹1,058 Cr |
Source: Scripbox, as of April 28, 2026. Past returns are not indicative of future performance.
A few things to notice in this table. The spread between the best and worst performers is enormous. That’s not typical of safer debt categories. And the small AUM of some top performers (DSP at ₹223 crore) raises a fair question about whether those returns can be replicated at scale.
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The Risks Associated With Credit Risk Funds
Credit risk (default risk)
If a company can’t pay its debts, the fund’s value takes a hit. And it’s not like with stocks, where things move gradually – a credit issue can cause a sudden, sharp drop. Remember Franklin Templeton in 2020?
The Franklin Templeton Episode
They shut down six debt schemes in April 2020, citing a bunch of problems—people wanting their money back and a major liquidity crisis in the corporate bond market, all thanks to COVID-19. These schemes were huge, with ₹25,215 crore in assets at the time. Investors were stuck, unable to get their money for years—it took the Supreme Court to step in, appoint a liquidator, and oversee the whole process. In the end, it wasn’t as bad as feared: investors got around ₹27,508 crore back, about 9% more than the securities were worth when the schemes closed. But the experience was brutal—investors were locked out for over two years, and it really shook their confidence. The category still hasn’t fully recovered.
Liquidity risk
Lower-rated bonds just don’t trade as much as the good stuff. When markets freeze up—like in March-April 2020 – fund managers can’t sell bonds for reasonable prices, which creates a huge problem. It’s like a bad loop: people want their money back, so the fund has to sell bonds at bad prices, which lowers the fund’s value, which makes more people want to pull their money out.
Concentration risk
Many credit risk funds only hold 20-30 different bonds. If one of those companies gets downgraded or defaults, it can cause major damage. Always check the fund’s top holdings before investing and see how much of the portfolio is in one company or sector.
Interest rate risk
Lower-rated bonds have duration risk too. If interest rates rise significantly, the market price of the fund’s holdings may fall, even if there are no defaults.
Comparison with Safer Debt Alternatives
The table below is based on returns from some big-name funds in each category, courtesy of Scripbox and Groww, which pull from AMFI and AMC data. Now, these aren’t category averages, just examples from well-known funds to give you a sense of the return range. They are not to be considered as recommendations.
| Category | Representative Fund | 1-Year Return | 3-Year Return | Credit Quality | Volatility |
| Liquid Fund | ICICI Pru Liquid (Direct) | 6.21% | ~7.1% | AAA/Sovereign | Very low |
| Corporate Bond Fund | ICICI Pru Corporate Bond (Direct) | 5.46% | 7.51% | Predominantly AAA | Low |
| Banking & PSU Fund | ICICI Pru Banking & PSU (Direct) | 5.4% | 7.41% | AAA/AA+ | Low |
| Credit Risk Fund | Aditya Birla SL Credit Risk (Direct) | ~13% | ~12.9% | AA and below | Moderate-High |
The returns are subject to changes and are based on category performance data. Sources: Scripbox (June 2026), Groww.
A few things jump out. That huge gap in 1-year returns between credit risk funds and the safer ones is pretty big, but context matters. Credit risk funds had a strong run in FY25, thanks to some one-off rating upgrades and a compression in credit spreads. Experts warn that a lot of this outperformance is a one-time thing and that the 9.30% category average return from last year might not stick around.
Now, if you look at the 3-year returns, things get a bit more layered. Corporate bond and banking & PSU funds have been running along, delivering 7-8% returns with way less volatility. Credit risk funds, on the other hand, have higher 3-year returns, but with a lot more ups and downs. And here’s the thing: with the tax treatment now being the same for all (slab rate), the difference in post-tax returns for someone in the 30% bracket isn’t as huge as you’d think.
How to Invest in Credit Risk Funds
Direct vs regular plan Always go with the direct plan. That 1-1.5% expense ratio difference between regular and direct plans may seem tiny, but it adds up big time over 3-5 years.
What to look for before choosing a fund:
- Portfolio diversification: Avoid those with more than 8-10% invested in a single spot. A solid credit risk fund should have a bunch of names: 30+, ideally, across various industries.
- Average credit rating: Funds with a portfolio average closer to AA are generally safer than those with a bunch of A or A-rated paper.
- Fund manager track record: This category is all about the manager’s skill. A good benchmark is how they performed in 2020. Make sure you check that.
- AUM size: Very small AUM funds can be vulnerable to redemption pressure, while very large ones might struggle to find quality investments without taking on too much concentration risk.
- Exit load: Most credit risk funds charge exit loads of 1–3% if redeemed within 1–3 years. Factor this into your horizon planning.
A minimum 3-year horizon is advisable. Shorter holding periods expose you to NAV volatility and the cost of exit loads.
Taxation
This is where credit-risk funds took a second major blow after the Franklin Templeton episode. For investments made before April 1, 2023, the earlier norms continue to apply: gains on units held for more than 24 months are taxed as LTCG at 12.5% without indexation. For units purchased before April 1, 2023 and redeemed after July 23, 2024, gains on holdings of 24+ months qualify as LTCG and are taxed at 12.5% without indexation. For all investments made on or after April 1, 2023, this distinction disappears entirely. Gains are taxed at your applicable slab rate regardless of how long you hold.
What this means in practice:
If you’re in the 30% tax bracket and you invest in a credit risk fund today, your entire gain is going to get taxed at 30%, which makes the post-tax return way less impressive than it looks on paper. Take a fund that returns 9% pre-tax, for instance: you’re looking at roughly 6.3% post-tax if you’re in the 30% slab. Meanwhile, a bank fixed deposit offering 7.5% will give you around 5.25%. The gap’s narrowed significantly.
For investors in the lower 20% bracket, though, the math is way more favorable. But for those in the 30% bracket, this tax change has basically leveled the playing field between credit risk funds and decent fixed deposits, which removes one of the main arguments for investing in this category in the first place.
Who Should Consider Credit Risk Funds?
Credit risk funds are suitable for certain types of investors:
- You fall into the 20% tax bracket or lower, where it still makes sense to get the post-tax yield advantage
- You have a 3–5 year investment horizon and won’t need the money during a market dislocation
- You’d like to use a small percentage (usually 5-10%) of your fixed-income holdings to diversify into higher-yielding debt
- You are okay with NAV volatility and the chance, though low in a good manager’s hands, that a credit event may occur
They are generally not appropriate as a substitute for capital preservation instruments or emergency funds or for investors who need predictable, guaranteed income.
Credit Risk Funds Frequently Asked Questions
Corporate bond funds are all about playing it safe. They invest mostly in top-rated, AAA paper. On the other hand, credit risk funds go for the slightly riskier AA-and-below paper, hoping to score higher yields. The risk and return profiles are pretty different, despite both being debt funds.
There are around 15 or 16 of these schemes still active, from big players like ICICI Prudential, HDFC, and Aditya Birla SL, among others. But this category has actually shrunk a lot since 2020. A bunch of smaller schemes even got wound up or merged.
Yes. If there’s a big default or downgrade in the portfolio, you could see some serious losses in just a day or a week. This happened to a few funds back in 2018, during the IL&FS crisis, and again in 2020, during the COVID credit crunch.
Ultimately, they got their money back, and then some: the total distributions were around ₹27,508 crore, which is about 9% more than the AUM at the time of closure. But here’s the thing: it took over three years, and they needed the Supreme Court to step in. The real lesson there is about liquidity risk: being locked in when you need your money can be a real problem.
SIPs can help smooth out some of the volatility, but they won’t save you from a credit event. If a key holding defaults, everyone takes a hit, regardless of when they bought in. So, SIPs are okay as a way to get in, but what really matters is picking a fund that’s well-diversified and has a solid manager track record.
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