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

A letter from the Editor


Dear Readers,

The coronavirus crisis has changed the world completely in the last few months. All of us have been locked into our homes, economic activity has come to a near standstill. Everyone has been impacted.

Including your favourite business and financial newspaper. Our printing and distribution chains have been severely disrupted across the country, leaving readers without access to newspapers. Newspaper delivery agents have also been unable to service their customers because of multiple restrictions.

In these difficult times, we, at BusinessLine have been working continuously every day so that you are informed about all the developments – whether on the pandemic, on policy responses, or the impact on the world of business and finance. Our team has been working round the clock to keep track of developments so that you – the reader – gets accurate information and actionable insights so that you can protect your jobs, businesses, finances and investments.

We are trying our best to ensure the newspaper reaches your hands every day. We have also ensured that even if your paper is not delivered, you can access BusinessLine in the e-paper format – just as it appears in print. Our website and apps too, are updated every minute, so that you can access the information you want anywhere, anytime.

But all this comes at a heavy cost. As you are aware, the lockdowns have wiped out almost all our entire revenue stream. Sustaining our quality journalism has become extremely challenging. That we have managed so far is thanks to your support. I thank all our subscribers – print and digital – for your support.

I appeal to all or readers to help us navigate these challenging times and help sustain one of the truly independent and credible voices in the world of Indian journalism. Doing so is easy. You can help us enormously simply by subscribing to our digital or e-paper editions. We offer several affordable subscription plans for our website, which includes Portfolio, our investment advisory section that offers rich investment advice from our highly qualified, in-house Research Bureau, the only such team in the Indian newspaper industry.

A little help from you can make a huge difference to the cause of quality journalism!

Sincerely,

Support Quality Journalism
  1. Comments will be moderated by The Hindu Business Line editorial team.
  2. Comments that are abusive, personal, incendiary or irrelevant cannot be published.
  3. Please write complete sentences. Do not type comments in all capital letters, or in all lower case letters, or using abbreviated text. (example: u cannot substitute for you, d is not 'the', n is not 'and').
  4. We may remove hyperlinks within comments.
  5. Please use a genuine email ID and provide your name, to avoid rejection.
You have read 1 out of 3 free articles for this week. For full access, please subscribe and get unlimited access to all sections.