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Types of Risks in Debt Mutual Funds


You might have frequently heard the notion that debt funds carry minimal risk, but this is misleading. Can any investment truly claim to be entirely risk-free? It seems doubtful. Investments differ in the level and type of risks they present. Simply because an investment that doesn’t focus on stocks can still be risky. However, it’s true that the risk associated with debt funds is comparatively lower than that of equity investments. To grasp the essence of these risks, it’s essential to comprehend how debt funds operate.

Debt mutual funds or debt schemes are investment vehicles that primarily invest in fixed-income securities such as government or corporate bonds, treasury bills, and other debt instruments like commercial papers, and certificate of deposits. While they are often considered safer than equity funds, they still carry certain risks that investors should be aware of.

Let us understand the types of risks involved before investing in a debt fund.

Investing in debt funds carries various types of risk. These risks include credit risk, interest rate risk, liquidity risk, among others. But the key risks which need to be considered before investing in Debt funds are Credit Risk and Interest Rate Risk.

Credit Risk (Default Risk)

Think about it like this: when you lend money to someone, there is a chance they might not be able to pay you back. This chance of them not repaying is called credit risk. Credit risk depends on how good the borrower is at paying back money, known as their ‘credit rating’. Agencies like CRISIL, ICRA, CARE etc., rate this ability. The better the rating, the better the chance they will pay you back, making your investment safer.

As explained above, credit risk is quantified through credit ratings, which are evaluations conducted by these credit rating agencies. These agencies assess the issuer’s financial strength and stability to meet their repayment commitments by evaluating their overall financial health and creditworthiness.

Illustration: Ratings & the Yield

Ratings Yield Time
Sovereign 7.27% 10 Year Gsec
AAA 7.60% 9 Year Corporate Bond
AA 10.50% 7 Year Corporate Bond
Please note: The yields are as of Dec 13, 2023.

This illustration clearly states that as credit risk increases, the anticipated return also rises proportionally. Therefore, when assessing a debt fund that claims to deliver exceptionally high returns, the primary scrutiny should focus on the portfolio’s credit risk.

Credit ratings are subject to change over time due to periodic evaluations of company performance, which determine the risk associated with them. Fund managers are primarily concerned not just with the risk of default but also with the potential downgrade in the credit rating of the debt instruments held in the portfolio.

A downgrade in credit rating adversely impacts the market value of the instrument, directly affecting the portfolio’s performance. On the other hand, an upgrade in credit rating increases the fund’s value, benefiting the overall portfolio.

Interest Rate Risk

Debt funds are sensitive to changes in interest rates. When interest rates rise, the value of existing bonds decreases, leading to a decline in the NAV (Net Asset Value) of debt funds. Conversely, falling interest rates can increase the value of bonds and boost the NAV.

This means, the relationship between the market price of a bond and interest rates is inversely related. As interest rates rise in the market, bond prices tend to decrease. For eg. If you have invested in a 10-year bond with a 10% interest rate. Initially, if you invest Rs 10,000 in this bond, you would receive Rs 1000 every year for 10 years, and in the final year, you would also get your initial Rs 10,000 back. This is the standard behaviour of bonds. However, consider a situation where the interest rate falls to 8%. Due to your bond offering a higher interest rate of 10%, its demand rises, subsequently increasing its price. Consequently, you would need to spend more to purchase the same number of units. This illustrates the risk associated with fluctuations in market interest rates as your securities are actively traded.

Consequently, the thumb rule here is that when market interest rates increase, bond prices tend to decrease, and conversely, when interest rates decline, bond prices generally rise.

Longer-duration bonds are more sensitive to interest rate changes than shorter-duration ones. Funds with longer average duration can experience higher volatility due to interest rate fluctuations.

Gilt Funds and Bond/Income Funds within the debt fund family are perceived to carry greater interest rate risk.

Liquidity Risk

Liquidity risk in debt funds refers to the potential difficulty of buying or selling assets within a debt fund without significantly affecting their market price. It’s the risk associated with the fund’s ability to convert its investments into cash quickly at a fair price when necessary.

Some bonds or debt instruments may not have a liquid secondary market, making it difficult to sell them quickly without impacting their prices. If a fund holds illiquid assets and investors rush to redeem their units, the fund might face challenges in meeting redemption requests without impacting NAV.

Debt funds hold various types of fixed-income securities with different levels of liquidity. Government bonds usually have higher liquidity compared to corporate bonds or lower-rated securities. The mix of these assets in a fund can impact its overall liquidity.

How should you handle these risks?

Should you avoid investing in debt funds altogether? Not necessarily! It depends on whether they fit your investment goals. The likelihood of these risks happening affects the returns you might get. It’s crucial to calculate and understand the risks involved in any investment. For instance, many people know that equity mutual funds are riskier than debt funds. But does everyone stop investing in stocks? No. That’s because higher risk can also mean the potential for higher returns.

When you compare the benefits of investing in debt funds, they might be more than the risks.

Consult the MMP investment experts to choose the right debt funds for you.

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