The Hindu Business Line : Not always risk-free

While the current equity market rout has led many to seek cover in debt options, it is important for investors to know that debt options, especially debt funds, are not without their share of risks, although of a lower degree than equity.

This article seeks to highlight one of the prominent risks faced by debt mutual funds — interest rate risk.

NAV fluctuations

Debt funds are often perceived as providing fixed return as they invest in instruments that typically have a set coupon/interest rate.

This is, however, a mistaken belief, for the simple reason that the NAV of a fund is not derived from just the income from the instrument; the NAV also fluctuates based on the market price of the debt security.

But why should the price fluctuate? Prices of debt instruments move in response to market perception of interest rate movements. Debt funds are therefore subject to interest rate risks.

Let us take the case of corporate bonds, one of the most common instruments in which a debt fund invests.

Suppose a debt fund invests in a bond issued by company X that has a coupon rate of 10 per cent on a face value of Rs 100.

When the market interest rate moves up to 11 per cent, company X cannot increase the rate, nor is it obliged to, as the coupon rate is already set.

In order to realign the Bond X’s yield to market rates (11 per cent), the bond price has to fall to Rs 90.9. In other words, in a rising interest rate scenario, bond prices fall, if their coupon rate is lower than market interest rate or the perceived interest rate.

Similarly, in a softening interest rate situation, when the bond’s coupon rate is higher than the market rate, bond prices rally to realign or bring down the yield to market levels.

Thus, when bond prices rally (on softening interest rates), the NAV of the debt fund holding such instruments too rise and vice-versa. In other words, the price of a debt instrument has an inverse relationship with interest rates.

Portfolio maturity

How does a debt fund manage this risk? Tweaking the fund’s portfolio maturity (average maturity period of instruments in the portfolio) is one of the key tools.

Suppose a fund manager anticipates a fall in interest rates in the market, he may choose to increase exposure to instruments with longer-term maturity. This provides scope for the bond prices to rally over a longer period, until it realigns with the falling market rates.

However, what if the actual rate cuts are lower than what the market anticipated?

In such cases too, the longer-dated instruments, that had rallied believing that there will be high rate cuts, run the risk of losing value to retain the market yields.

Thus in uncertain times/rallying rate regimes, a typical flexi-debt fund may prefer to retain a lower portfolio maturity.

Clear evidence of falling interest rates may prompt fund managers to increase portfolio maturity.

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