Risk and return derive from each other. Though computing return for an investment is mostly a straight forward process, one can’t say the same thing about risk. It is normally perceived that there is no risk in case of debt mutual fund schemes. However, debt instruments, and by extension, debt mutual funds are also exposed to certain risks.
Risks associated with Debt Funds
The risks associated with Debt Funds are as under:
- Credit Risk, or Default risk: This is the risk that the borrower does not repay the amount borrowed, or defaults on payment of interest obligations. Money lent to Government is free from Credit risk, as The Government will not default on its commitment. If money is lent to Corporates, then there is a possibility that the borrowing corporate may default. Credit Ratings help us to understand the extent of credit risk associated with lending to a particular corporate
- Interest Rate Risk: Interest rates keep moving up and down. Let us say, you made a Fixed deposit of Rs.10,000 for a period of 5 years with a particular bank at a particular rate of interest, say 10% p.a. It means, for the next 5 years, you will get a fixed interest of Rs.1,000 and your initial investment of Rs,10,000 will be returned to you after 5 years. After 1 year, the same bank, due to various reasons, is now offering 12% p.a. interest on its deposits. While there is no change in the amount of interest being paid to you, you still feel bad, because you are getting lower interest than someone else who invested after the interest rates went up.
Bonds issued by Government and Corporates are all traded in the market. If you had bought a Bond which offers 10% p.a. interest and interest rates went up after that, the value of the bond in the market will fall. In other words, if you wish to sell the bond and take back your money, you will not get Rs.10,000. You will have to settle for lower value, as your bond earns lower than another bond. The buyer will pay you lesser amount as he is getting lesser amount from the bond that is held by you. Thus, the risk of fall in market value of bonds due to increase in interest rates is called Interest rate risk. Of course, the bond values will go up if interest rates fall.
- Inflation Risk: We understood that the Government will not default on its commitment. This is because the Government can repay the debt by printing more money. However, when Governments print money, money loses its purchasing power. A bag of Rice, which is presently costing, say, Rs.1200, could be bought for Rs.1000 3 years from now. So, if the Government takes Rs.1000 from you now and gives back Rs.1000 after 3 years, you get back your money, but the value of money is lower, which is a loss to you. The fall in purchasing power of money is called inflation. Investments in Debt are exposed to Inflation risk
- Liquidity Risk: Lastly, it is possible that the borrower may not be able to repay the amount when you need the money. This could be for various reasons, but if you need the money at a particular point in time, but are not able to get it, you may have to do a distress sale of such investments, resulting in loss. This risk is called Liquidity risk. This risk is very clearly visible in the recent case of 6 Debt Funds managed by Franklin Templeton India Fund. Investors who invested money for “ultra short term” may not get back their money for a very long period.
Real risks are difficult to identify
Several factors contribute to the complexity of risk assessment of debt funds. Here are a few reasons why identifying risks in debt funds is anything but easy:
- When the economy is booking, the value of bonds and debt funds keeps increasing on a daily basis due to interest accrual. The funds do not experience high volatility, falling interest rates can increase bond values and therefore, the investor does not see any negative returns. Such excellent fund performance can mask the underlying risks.
- Debt instruments normally carry a credit rating issued by a Credit Rating Agency. However, there are many independent entities that also provide a rating of various mutual fund schemes. Sometimes, a credit rating agency also rates various fund schemes. While the investor should be looking at Credit rating of underlying debt instruments held by a debt fund, he/she actually follows fund ratings. The rating might not represent the accurate picture of the debt fund. Though ideally, it should be constructed to capture the fund’s credit movements, the rating mostly focuses on the returns earned by the fund over different time horizons. The underlying credit risk is not clearly brought to the fore.
- It is challenging to define credit risk. Though debt instruments are rated and each rating signifies a particular level of risk, there are enough examples of the ratings not being representative of the risk. Debt instruments with higher ratings have defaulted, with rating agencies lowering the rating after the default. In light of such scenarios, even regular scrutiny of portfolios may not assure predictable results. Also, it is challenging to determine different papers that may belong to the same group, which amps up the group concentration. To make the connection, one needs to step away from the rating rationales.
- As the fund redemption increases, liquidity risks become more visible. It is too late to wait for month-end portfolio data to identify it, as it can happen in a few weeks or even days. Though a high negative net cash may indicate borrowing to meet redemptions, it may occur due to other factors such as interest rate derivatives.
Reasons to invest in a debt fund
The existence of aforementioned risks does not mean an investor must stay away from debt funds. Debt Funds can be considered for investments for the following reasons:
- Stability: Debt instruments provide stability to one’s portfolio. The investor knows that he/she can always fall back on this asset class. If you have invested in Gilt Funds, you are assured that you will get back your money and some decent returns, provided you have held it for a reasonably long period of time.
- Higher Tax adjusted returns: If one holds a Debt fund for a period of more than 3 years, one can benefit from indexation and a lower tax rate, which means, post tax returns on a debt fund are higher than if you invest in a Fixed Deposit or bond for a similar period.
- Stable returns: Overnight or liquid funds can be considered if you are looking to park your money for a short period of time for steady returns without hits. The credit risk and volatility in these funds is minimal.
- High risk: Investors with an appetite for risk can consider funds/instruments that are high on credit risk. These can result in high yield if there is no default. However, this requires a greater understanding and analysis of the risks involved.
Tips for managing your debt fund
- Investment in Debt Funds should be as per your asset allocation.
- Clearly identify time horizon of investment and choose the funds accordingly.
- Unless you have an appetite for risk, stick to GILT Funds.
- If investing for longer term, Constant Maturity funds can significantly reduce the interest rate risk
- If the investment horizon is less than 3 years, one is better off with liquid funds or overnight funds, rather than dabble with GILTs and other medium/ long duration funds
- Diversify across fund houses. Limit the exposure between 10% to 25% even with high-quality funds.
- Keep track of your fund’s AUM size, as AUM of short and liquid funds, is often volatile because of the movements of corporate treasury money.
- Understand credit risk categories are riskier than equity ones.
- Take the help of a SEBI Registered Investment Advisor (RIA) to help you in making the right investment choice.Shift your money to bank deposits and other investments that provide liquidity and protect capital. Do not chase the extra 50 basis points of return, as it is not worth the risk. Even debt funds do not provide 100% capital preservation.