All mutual funds are subject to market risks. Though, with varying degree of risks come chances of earning higher returns.

One of the risks that debt funds face is credit risk. Most debt instruments that debt funds invest in carry a credit rating. The rating reflects the chances of a company to honour its interest and principal payment commitments. The higher the rating, the better its credit quality. Some debt funds invest in lower-rated scrips as these offer higher yields to lenders. The probability that a lower-rated scrip fails to pay interest or principal in time is called credit risk.

Apart from higher yields, a low-rated scrip’s listed price goes up if and when the credit rating improves. But if the rating deteriorates, it is bad news for debt funds.