What is credit risk in Debt Funds?
If the company’s cash flows are impacted due to business failure or any other reason, its ability to pay interest and even principal is uncertain – technically known as credit risk.
Jun 2025
4 mins read
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Imagine you have lent money to a friend who has agreed to pay you back in 3 months. After 3 months, he informs you that he can’t pay back immediately as he has lost his job. You don’t expect any interest on the money but at least wish to get your principal back. Most of us would have faced this kind of situation when we are unable to get back the money we lent.
Similarly, institutions borrow money from a variety of sources including banks and mutual funds by issuing bonds/debentures/other securities. The borrower agrees to pay regular interest on the bonds and return the principal at the end of the bond’s maturity. If the company’s cash flows are impacted due to business failure or any other reason, its ability to pay interest and even principal is uncertain – technically known as credit risk.
The company’s creditworthiness or ability to pay back the loans is ascertained by credit rating agencies based on company’s business outlook and financial health. The credit rating agencies assign ratings which range from AAA to D – denoting the investment worthiness and probability of default. AAA denotes highest credit rating while D denotes default. The ratings are reviewed periodically by agencies like CRISIL and ICRA and either upgraded or downgrades as per the company’s evolving scenario. Credit analysts and debt fund managers keep a hawk’s eye on each of the securities of the portfolio to avoid any potential risk of default.
Credit risk is inherent while investing in Debt mutual funds while the degree of risk varies across the fund categories at a fund level. For instance, A Credit Risk Fund will have relatively higher credit risk compared to Gilt Funds, where credit risk is almost negligible as these securities are backed by the government. The credit risk of each fund differs, which can be ascertained by the Potential Risk Class (PRC).
A fund’s credit risk is disclosed by the fund house which ranges from relatively high to relatively low - giving you an indication of the risk you are taking. We have compiled the list of Debt Fund categories and their corresponding credit risk for easy reference. Do note that Hybrid Funds also invest some portion in debt so you may have to check the credit quality of each
Hybrid Fund separately.
How do mutual funds mitigate credit risk? SEBI norms prescribe mutual funds to not invest more than 10% of NAV in debt instruments by a single issuer, which can go up to 12% with prior board approval. Moreover, mutual funds invest in multiple issuers so the risk is diversified. Thus, any default by a single issuer may not have significant impact on the fund’s performance.
The yield on lower rated paper tends to be relatively higher as they compensate investors for taking more risk. In the same token, securities that command a higher rating (AAA) offer lower yield due to their safety.
Summing up, investing in funds with higher credit risk may help you earn extra return but it comes with a higher risk.
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PGIM India Asset Management Private Limited
(CIN - U74900MH2008FTC187029)
Toll Free Number: 1800 266 7446
Email: care@pgimindia.co.in
This is an Investor Education and Awareness Initiative by PGIM India Mutual Fund.
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MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY. Read more
All the Mutual Fund investors have to go through a one-time KYC (Know Your Customers) process. Investor should deal only with the Registered Mutual Funds (RMF). For more info on KYC, RMF and procedure to lodge/redress any complaints, visit https://www.pgimindia.com/mutual-funds/ieid.
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY. Read more
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