Credit risk is the danger that a bond issuer defaults on interest or principal payments — primarily relevant for debt mutual fund investors.
When a mutual fund holds bonds, the issuer (company, bank, or government) has promised to pay regular interest and return the principal at maturity. Credit risk is the probability that the issuer fails to make these payments. Higher credit risk issuers (lower credit ratings: BBB, BB, B) offer higher interest rates (yield premium) to compensate investors. Lower risk issuers (AAA, AA, government) offer lower yields. Credit events — downgrades or defaults — cause sudden and sharp NAV drops in debt funds holding affected bonds.
Credit risk is the risk that someone you lent money to doesn't pay you back. In 2019–2020, several Indian debt funds suffered because DHFL, IL&FS, and Yes Bank bonds (which they held) defaulted or were downgraded. Investors in those funds saw sharp NAV falls overnight. The lesson: higher yield in a debt fund always means higher credit risk — there's no free lunch.
Credit rating agencies (CRISIL, ICRA, CARE) rate bond issuers: AAA (highest) to D (default).
Each rating step down increases the default probability and requires a higher yield premium.
SEBI mandates debt funds to disclose the credit rating distribution of their portfolio monthly.
Gilt funds: zero credit risk (government). Overnight/Liquid: very low. High-yield/credit risk funds: high.