Many investors have a general perception that while equity and equity mutual funds are volatile, debt mutual funds are risk free. They also see debt funds as an alternative to fixed deposits which can yield higher returns than the latter. The primary reason behind this misconception is that investors fail to understand how a debt fund works. Debt funds are risky for sure and unlike equity, the former is much more difficult for the retail investors to understand. Not just investors, even mutual fund agents may not correctly understand all the risks related to debt funds.
Let us first understand how a debt mutual fund works:
When you invest in a debt fund, the fund manager goes out and buys fixed income instruments for you like bonds, corporate deposits, government securities, commercial paper, treasury bills, etc. These instruments offer a fixed interest rate and the interest income accruing from these instruments is reflected in the net asset value (NAV) of the debt mutual fund. These investments are tradable in the market. So capital gain/loss accruing from the sale of these instruments will also reflect in the NAV of the debt mutual fund.
Now let us understand the risks that debt mutual funds face:
Interest rate risk
Interest is the reward you get when you invest your money in a fixed income instrument, say a bond. Interest rates and the price of a bond are inversely co-related, i.e., they move in opposite directions. So, when interest rates fall, the price of existing bonds offering higher interest rate moves up and vice versa. This price gain/loss is reflected in the NAV of a debt mutual fund. The longer the maturity of a bond, higher is the risk of fluctuation in interest rates. So, if you invest in a debt mutual fund with a portfolio of bonds having longer maturity, say between 7-10 years, then your fund is exposed to higher volatility because of the higher oscillation in interest rates. The performance of any debt fund hinges primarily on the interest rate call taken by the fund manager. So, suppose the fund manager predicts that interest rates will fall and accordingly buys long-term bonds bearing high interest rate in portfolio. But instead, interest rates rise further. The price of long-term bonds which the fund manager had accumulated in his portfolio goes down and so does the debt fund’s NAV. This is how you can lose money in a debt mutual fund.
Credit risk
The second major risk is the risk of default by the borrower, also called the credit risk, i.e., when the borrower is unable to repay the interest and the principal amount. Debt mutual funds are allowed to invest in debt papers that are rated investment grade by credit ratings agencies. But within this band of investment grade, it is possible for fund houses to invest in lower-rated papers than the paper with high safety in the market. When things go wrong for the firm and it is perceived to be or unable to repay the borrowed money to its creditors including the mutual fund, the credit ratings can drop sharply and the value of the fund suffers. If your fund manager invests in low quality credit paper, you can lose money in case the borrowing company defaults or shows signs of it.
Liquidity risk
This arises from credit risk in a bond issued by the company. When the company defaults on its borrowers, there is a big redemption pressure of its bonds. The liquidity for such company’s bonds dries up as there are not many takers for it. Such bonds thus become illiquid, posing risk for the debt fund manager holding them as they are unable to sell in the money market.
Inflation risk
Inflation can result in a surge in interest rates which again poses risk for debt funds. Secondly, inflation can eat into your returns on debt mutual fund.
Debt mutual funds can post negative returns
Recently, in September 2018, IL&FS, one of India’s largest financiers and developers defaulted on few inter-corporate deposits and bond payments. Rating agencies downgraded the company’s credit ratings by several notches from AAA rated bonds (highest quality, low risk) to BB (moderate risk) and then after a few days to D (default or possibility of default, junk quality). Many debt mutual funds that had invested in the then high-quality bonds issued by IL&FS were affected as the prices of the IL&FS high quality paper suffered a steep downgrade. Some mutual funds with high exposure to bonds of IL&FS and its group companies posted negative returns since September 2018. These are debt mutual funds having a fixed maturity plan, i.e., they are closed ended funds and cannot be redeemed before maturity. Refer to the table below:
How to tackle debt mutual fund risks?
When you invest in a debt mutual fund, then it is important to select the appropriate fund based on your financial goal and risk appetite. There are various categories of debt mutual funds available where you can invest depending upon your investment horizon, long and short. If you want to take advantage of interest rate cycles over a long period of time, opt for a dynamic bond fund. For a short to medium term horizon, choose liquid funds or short duration funds as both interest rate risk and credit risk are extremely low in these funds. Credit opportunities fund invest in low quality papers for a higher yield. So, if you have a time horizon of at least three years, want higher returns and can take greater risk, then you can go for credit opportunities fund. Otherwise, be careful about the credit risks of a debt fund and prefer one with a high investment grade portfolio. You can consult an expert investment advisor who can guide you in selecting the appropriate debt fund and in sync with your goals and risk appetite.