Credit risk and spreads
What a rating tells you, why company bonds yield more than government bonds, and what a downgrade does
Bond yields as on 1 September 2026; fund assets as on 31 August 2026
Verified 12 October 2026
For training and education only. Not investment advice.
Trainer notes
Open by asking: two bonds mature on the same day, one pays 7% and the other 8.5%. Why would anyone buy the 7% one? Take a few answers. The deck is about what the extra 1.5% is payment for.
Credit risk is the chance that a borrower pays late, pays less, or does not pay at all.
Lenders want to be paid for carrying that chance. The extra yield they ask for, over a government bond of the same maturity, is called the credit spread.
Trainer notes
This is a different risk from the one in the previous deck. Interest-rate risk moves the price of every bond, including government bonds. Credit risk is about one borrower's ability and willingness to pay.
The rating scale, from AAA to D
A credit rating is a rating agency's opinion on how likely a borrower is to pay interest and principal on time.
| Long-term rating | Risk level in SEBI's mapping | Where it sits |
|---|---|---|
| AAA | Lowest credit risk | Investment grade. An opinion, not a guarantee. |
| AA+, AA, AA− | Very low credit risk | Investment grade. '+' and '−' rank within a band. |
| A+, A, A− | Low credit risk | Investment grade. |
| BBB+, BBB, BBB− | Moderate credit risk | Investment grade. BBB− is the lowest. |
| BB+ and below, down to D | BB: moderate risk of default. B, C and D: high to very high risk of default. | Below investment grade. D: in default, or expected to be soon. |
Sources: SEBI circular of 7 Oct 2026 (Credit Risk-o-Meter, for listed bonds, not MF schemes); SEBI Master Circular, 20 Mar 2026; a rating agency's scale (for D).
Trainer notes
All SEBI-registered rating agencies use the same symbols, with the agency's name in front. Short-term paper has its own scale (A1+ to A4 and D). SEBI's circular of 7 October 2026 makes a colour-coded 'Credit Risk-o-Meter' compulsory for listed debt securities; it comes into force 45 days after issue and applies to bonds, not to mutual fund schemes. Central government securities are not rated on this scale.
A spread, and what happens when it widens
THE SET-UP
Two bonds, each with ₹1,000 face value and three years left.
A government bond yields 7.00%.
A company bond pays an 8.5% coupon once a year and trades at ₹1,000, so it yields 8.50%.
- Credit spread = 8.50% − 7.00% = 1.50 percentage points. Markets call this 150 basis points (1 basis point = 0.01 percentage point).
- Bad news about the company arrives. Buyers now want 9.50% from it. The government bond still yields 7.00%.
- New price of the company bond: ₹85 ÷ 1.095 + ₹85 ÷ 1.095² + ₹1,085 ÷ 1.095³ = ₹974.91.
- The spread is now 250 basis points. The bond is worth ₹25.09 less, a fall of 2.51%, and no payment has been missed.
Result: A wider spread means a lower price, even while the borrower is still paying on time.
Illustration with assumed figures. Not a forecast.
Trainer notes
Work the third step on a calculator: 85 ÷ 1.095 = 77.63; 85 ÷ 1.199025 = 70.89; 1,085 ÷ 1.312932 = 826.39; total 974.91. The method is the same as in the bond prices deck; only the reason for the higher yield is different.
What lenders ask for, rating by rating
| 3-year yield (%) | |
|---|---|
| Government | 6.49 |
| AAA | 7.45 |
| AA | 8.22 |
| A | 9.48 |
Read the chart
- Spread over the 3-year government bond: AAA 96 basis points, AA 173, A 299.
- 100 basis points make 1 percentage point.
- The steps down the scale are not equal: government to AAA 96 basis points, AAA to AA 77, AA to A 126.
- Spreads move every day. A year earlier the 3-year AA spread was 139 basis points.
Source: indicative corporate and government bond yields for 1 Sep 2026, from a fund-house fixed-income tracker dated 2 Sep 2026 (secondary source).
Trainer notes
These are indicative yields for a rating band, not quotes for any one bond; two AA bonds can trade at quite different yields. The 3-year government figure is the tracker's own, unlike RBI's single-bond yields. The spreads are worked from the rounded yields shown; the tracker's own 3-year A spread is 298. Refresh these at each month-end, using market figures that are at least 30 days old. Market figures are shown with a lag of at least 30 days, in line with SEBI's norms on price data used for education. Do not call any spread high, low or attractive.
Why spreads widen
Trouble at the borrower
Weak results, a missed payment or a rating downgrade makes buyers ask for more yield from that borrower.
Trouble in its sector
When one borrower in a sector fails, lenders often become wary of similar borrowers, including sound ones.
A weaker economy
When growth slows, more borrowers are expected to struggle, so spreads tend to widen across ratings.
Cash becomes scarce
When money is tight or funds face redemptions, lower-rated bonds are hard to sell and buyers want a bigger discount.
A move to gilts
In a scare, investors move towards government bonds. Government yields can fall while company bond yields rise.
Trainer notes
These are the usual drivers, not a complete list, and more than one is normally at work. Spreads also narrow for the opposite reasons. Do not predict which way spreads will move.
When a bond in a debt fund is downgraded
A debt fund values nearly all its bonds at market-based prices daily, so NAV carries a credit event at once.
The bond is marked down
Its valuation must reflect the credit event. NAV falls that day, in line with how much of the bond the fund holds.
A side pocket may be created
If the bond falls below investment grade, the AMC may move it to a segregated portfolio. Trustees must approve.
Holders get matching units
Each investor on the day of the event gets as many units in the segregated portfolio as in the main one.
The main fund carries on
Buying and redeeming continue in the main portfolio. Side-pocket units cannot be redeemed; they are listed instead.
Recoveries go to holders
Recovered money is paid out in proportion to units held. No investment and advisory fee is charged on that portfolio.
Source: SEBI Master Circular for Mutual Funds, 20 March 2026, paragraph 5.5 (creation of segregated portfolio in mutual fund schemes).
Trainer notes
Illustration with assumed figures: a fund holds 4% of its assets in a bond that is marked down by half; NAV falls 2% that day. A segregated portfolio is optional and possible only if the scheme's SID provides for it. Trustee approval must come within one business day, and purchases and redemptions are suspended until then. Units of the segregated portfolio must be listed within 10 business days. For unrated paper the trigger is an actual default; for bank AT1 and Tier 2 bonds it is a write-off or conversion to equity.
Credit stress, and the rules that followed
| When | What happened | What followed |
|---|---|---|
| 2018 | A large infrastructure finance group, IL&FS, defaulted on its borrowings. On 1 October 2018 the Government moved the NCLT, which replaced its board. | SEBI permitted segregated portfolios in debt schemes on 28 December 2018. |
| 2019 | RBI superseded the board of a housing finance company, DHFL, on 20 November 2019, citing governance concerns and payment defaults. | RBI appointed an administrator for the company. |
| April 2020 | In the Covid-19 shock some debt schemes were closed. RBI said the stress was confined to the high-risk debt fund segment. | RBI opened a ₹50,000 crore special liquidity facility for mutual funds on 27 April 2020. |
| June 2021 | SEBI issued its Potential Risk Class matrix circular on 7 June 2021. | From 1 December 2021 each debt scheme states the most interest-rate and credit risk it may take. |
Sources: IL&FS 'Significant developments' page; RBI press releases of 20 Nov 2019 and 27 Apr 2020; SEBI circulars of 28 Dec 2018 and 7 Jun 2021 (effective date per a press report of June 2021).
Trainer notes
Keep to what the official records say and do not name fund houses or schemes. The point for the room: credit events do happen, they can arrive in clusters, and two of today's safeguards, segregated portfolios and the Potential Risk Class, were written after these episodes.
The Potential Risk Class matrix
Each debt scheme picks one of nine cells. The cell is the most risk it may take, not what it holds now.
| Rate risk limit ↓ Credit risk limit → | Class A: relatively low (CRV 12 or more) | Class B: moderate (CRV 10 or more) | Class C: relatively high (CRV below 10) |
|---|---|---|---|
| Class I: relatively low (Macaulay duration up to 1 year) | A-I | B-I | C-I |
| Class II: moderate (Macaulay duration up to 3 years) | A-II | B-II | C-II |
| Class III: relatively high (any Macaulay duration) | A-III | B-III | C-III |
CRV is the credit risk value, a weighted average: government securities 13, AAA 12, AA+ 11, AA 10, AA− 9 and so on. Source: SEBI Master Circular for Mutual Funds, 20 Mar 2026, para 6.18.
Trainer notes
Macaulay duration is explained in the next deck; for now, read it as a measure of how long the fund's bonds are. A scheme may run less risk than its cell allows. Moving to a cell with more risk counts as a change in a fundamental attribute. The matrix sits alongside the scheme category and the riskometer; it does not replace them. Example: a gilt fund holds government securities (CRV 13) but can be in Class III for interest-rate risk, so it shows as A-III.
Credit risk funds: the rule and the size
Credit Risk Fund is one of SEBI's 17 debt scheme categories. It is a small part of debt fund assets.
- MINIMUM IN AA AND BELOW
- 65%Of total assets, in corporate bonds rated AA and below. AA+ bonds do not count.
- CREDIT RISK FUND ASSETS
- ₹21,998 crNet assets of all credit risk funds on 31 August 2026.
- SHARE OF DEBT FUND ASSETS
- 1.1%Of ₹19,33,476 crore in debt-oriented schemes on 31 August 2026.
Sources: SEBI Master Circular for Mutual Funds, 20 Mar 2026, para 3.8.2 (category definition); AMFI Monthly Note, August 2026 (assets). Share computed: 21,998 ÷ 19,33,476.
Trainer notes
A credit risk fund holds lower-rated bonds by design, in exchange for a higher portfolio yield. That yield is not a promised return: it assumes every borrower pays on time. Other categories can hold lower-rated bonds too, within their own limits, so always look at the Potential Risk Class and the portfolio. Do not describe the category as suitable or unsuitable for anyone.
Four things people get wrong
Misconception'AAA means it cannot default.'
What is trueAAA means the lowest credit risk on the scale, not zero. A rating is an opinion, and it can be cut later.
Misconception'A higher YTM means a higher return.'
What is trueYTM assumes every payment arrives on time. A higher YTM usually means lower-rated or longer bonds in the portfolio.
Misconception'A side pocket means the money is gone.'
What is trueIt only separates the troubled bond. Recoveries go to whoever holds the side-pocket units, issued on the day of the event.
Misconception'Only credit risk funds carry credit risk.'
What is trueAny debt fund that holds company bonds carries some. The Potential Risk Class shows the most a scheme may take.
Trainer notes
On the third point, be straight: recovery can be full, partial or nil, and it can take a long time. Side-pocket units can be sold on the exchange, so recoveries go to whoever holds them when the money is paid.
Check yourself
Question 1: A 5-year government bond yields 7.10%. A 5-year company bond yields 8.60%. What is the credit spread in basis points?
Answer: 150 basis points. 8.60% − 7.10% = 1.50 percentage points, and 1 percentage point is 100 basis points.Question 2: A debt scheme is placed in cell B-II of the Potential Risk Class matrix. What is the most risk it may take?
Answer: Interest-rate risk: Macaulay duration of up to 3 years (Class II, moderate). Credit risk: a credit risk value of 10 or more (Class B, moderate). It may run less risk than this, not more.Question 3: A bond in a fund falls below investment grade and the AMC creates a segregated portfolio. What does an investor who held units that day now hold?
Answer: The same number of units in two portfolios: the main portfolio, which can be bought and redeemed as usual, and the segregated portfolio, which cannot be redeemed but is listed, and which pays out any money recovered.
Sources and disclaimer
Sources for the figures in this explainer
- Rating-to-risk mapping: SEBI circular, 7 Oct 2026, Credit Risk-o-Meter for listed bonds (not MF schemes).
- Segregated portfolios (para 5.5), Potential Risk Class (para 6.18), debt categories (para 3.8.2): SEBI Master Circular for Mutual Funds, 20 March 2026.
- 3-year yields, 1 Sep 2026: indicative corporate and government bond yields from a fund-house fixed-income tracker dated 2 Sep 2026 (secondary source).
- Fund assets on 31 August 2026: AMFI Monthly Note, August 2026.
- 2018 to 2021: IL&FS 'Significant developments' page; RBI press releases, 20 Nov 2019 and 27 Apr 2020; SEBI circulars, 28 Dec 2018 and 7 Jun 2021; a press report of June 2021 (1 Dec 2021 date).
- The worked example and the 4% holding in the notes use assumed figures, not quotes for any actual bond or scheme.
This material is for training and investor education only. It is not investment, tax or legal advice and is not a recommendation to buy, sell or hold any security or scheme. Examples use assumed figures unless a source and date are shown. Mutual fund investments are subject to market risks; read all scheme related documents carefully. Trustner Asset Services Pvt. Ltd. is an AMFI-registered Mutual Fund Distributor (ARN-286886).