Mutual Funds

Understanding risks in debt funds

Waqar Naqvi | Updated on May 18, 2020 Published on May 17, 2020

The spread of risks has to be commensurate with the degree of expected returns

Between the two statements — ‘Mutual Funds Sahi Hai’ and ‘Mutual Fund Investments are Subject to Market Risks’ — lies a plethora of information which investors need to understand. It is this understanding that ultimately results in keeping risks at a minimal and returns at an optimum level. Mutual funds are said to be retail investors’ route to the capital market. However, selecting the right type of fund poses a challenge to investors.

Investing is a complex art, but it takes no rocket science to tell an investor that the two most important factors that should guide him/her are risks and returns. While equity is a ‘high risk-high return’ game, debt is considered to be a ‘low risk-low return’ proposition.

However, ‘low risk-low return’ does not necessarily mean that investors should not examine where they are investing their monies and simply be at ease for the tenure.

A judicious mix of debt and equity funds will help in optimising the overall returns for investors. Investing in debt funds comes with its own sets of challenges and opportunities. Considering the developments since September 2018, investors need to understand the risks involved in debt funds in order to avoid pitfalls.

So, how do you identify the risks in debt fund investing?

Credit risk

There are various factors that need consideration to evaluate the risk involved in debt funds. The two most important ones are the credit risk and the interest-rate risk. On a basic level, mutual funds collect money from investors and invest that money in various instruments.

Credit risk is the risk of a borrower failing to repay the money that the fund manager invests in his/her instruments. The credit ratings assigned to various debt instruments by rating agencies such as CRISIL, ICRA and CARE help identify the risk involved in these instruments. A higher rating means a lower risk, and vice versa.

Interest-rate risk

Prevalent interest rates and their expected direction play a huge role in calculating the future returns from debt instruments. Bond prices (debt instruments) have an inversely proportional relationship with interest rates.

Rising interest rates result in lower bond prices as the yield goes down, and vice versa. For a bond with a coupon rate of 8 per cent annually, if the prevalent interest rates go up to 9 per cent, the bond would have to trade at a discount to its issue price of ₹100 at ₹97.64 to stay at par with its coupon yield.

Smaller risks

While the two most important risk factors have been discussed above, there are smaller but equally important factors that need consideration while investing in debt funds. The dispersion of a portfolio is something that needs careful attention. Holding too many eggs in the same basket tends to be risky is a wisdom already known. No fund manager does this.

However, in times like the Lehman crisis of 2008, acute and unexpected developments may bring about a situation where redemptions from a fund are higher than usual (not necessarily intended by the fund manager but due to investors needing more money than usual to tide over a crisis), and the fund manager liquidates the papers that can be liquidated to service the higher redemptions, thereby bringing about a concentration risk.

This adds to the significance of monitoring the portfolio.

Even otherwise, chasing returns can sometimes lead to a bumpy ride and unwarranted accidents, damaging your portfolio. With time, though, most or all of the money may come back, but this may take some months and may not be available to an investor as per his/her requirement. The spread of risks has to be commensurate with the degree of returns expected from your investments. A slightly lower takeaway is any time a better option.

The writer is CEO, Taurus Mutual Fund

Published on May 17, 2020

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