Credit Ratings in Debt Funds, Explained Simply

A debt fund lends money by buying bonds and similar instruments issued by governments, banks and companies. In return, those borrowers pay interest and repay the amount on a set date.

The main risks are that a borrower fails to pay, and that bond prices change when interest rates move. Our page on debt funds explains both.

A credit rating is an opinion from a rating agency about a borrower ability to pay interest and repay on time. It is based on the borrower finances, business, debts and other factors.

Rating agencies in India are registered with and regulated by SEBI. A rating is an opinion, not a promise.

AAA: the highest safety for long-term company debt. Very low default risk.

AA: high safety, slightly more risk than AAA.

A: adequate safety, more sensitive to bad times.

BBB: moderate safety, the lowest of the "investment grade" ratings.

Below BBB: higher risk of default. Plus and minus signs show finer steps within a grade.

Short-term instruments like commercial paper and certificates of deposit use a separate scale, such as A1+ for the highest safety. Liquid and money market funds hold many of these.

Our page on liquid funds explains what these funds hold.

"Sovereign" in a fact sheet means government securities issued by the central government, and sometimes state government loans. These carry practically no default risk, because the government is the borrower.

They still carry interest rate risk, as their prices move when rates change. Our page on gilt funds explains funds that hold mainly government securities.

Borrowers with lower ratings must offer higher interest to attract lenders, because the risk of not being repaid is higher. A debt fund holding lower-rated bonds may show a higher yield.

That higher yield is payment for taking more risk. If a borrower defaults, the fund can lose much more than the extra interest it earned. Our page on credit risk funds explains this trade-off.

Rating agencies review ratings regularly. If a borrower finances weaken, the rating can be cut, sometimes by several notches quickly. A downgrade usually lowers the bond price, which reduces the fund NAV.

In serious cases, a fund may separate the troubled bond through side pocketing. Our page on side pocketing explains how.

Fact sheets usually show a breakdown of holdings by rating: how much is Sovereign, AAA, AA and below. They also list the top holdings with their ratings.

A fund with mostly Sovereign and AAA holdings carries low credit risk. A fund with a large share below AA carries more. Our page on the fact sheet explains where to find this.

Debt funds also show a potential risk class, a simple grid that combines credit risk and interest rate risk. It tells you the maximum risk the fund may take on each, based on its rules.

This helps compare funds quickly. Our page on the riskometer explains this and other risk labels.

Emergency fund and near goals: prefer funds holding mostly Sovereign, AAA and A1+ instruments. Safety matters more than a little extra yield.

Longer debt holdings: some investors accept a small share of AA, but large exposure to lower ratings is best avoided unless you understand the risk.

Our page on building an emergency fund explains where safety money belongs.

Two funds in the same category can hold very different credit quality. A short duration fund, for example, may hold mostly AAA or a fair share of AA. Always check the actual holdings.

Our page on short duration funds shows how this varies.

Even good ratings can hide risk if a fund puts a large share in one borrower or one group of companies. Check the top holdings and their weights. A spread across many borrowers is safer.

There have been cases where highly rated borrowers were downgraded suddenly and defaulted soon after. Ratings help, but they are not a substitute for diversification and caution.

That is why many investors prefer debt funds with mostly government and top-rated holdings for important money.

Some categories have rules that push credit quality higher. Banking and PSU funds hold mainly debt of banks and public sector companies. Corporate bond funds must hold mainly the highest rated corporate bonds.

Our pages on banking and PSU funds and corporate bond funds explain these categories.

Imagine two short-term debt funds. Fund A holds mostly government securities and AAA bonds. Fund B holds a large share of AA and A rated bonds, and shows a slightly higher yield.

In normal times, Fund B may earn a little more. But if one of its lower-rated borrowers runs into trouble, Fund B could lose far more than that extra income. For emergency money, Fund A type holdings are usually the calmer choice. This is an illustration, not a recommendation.

• Ratings show repayment safety.
• Sovereign and AAA are the safest.
• Lower ratings pay more but carry more risk.
• Check holdings, not just the fund name.

We are distributors rather than investment advisers and we recommend no schemes. If you want help checking the credit quality of your debt funds, get in touch.