In “Is equity all that risky?” and “Make your portfolio safer with risky investments” we looked at the mindset of investors who believe that equity is risky and their portfolios would be safer with debt instruments or debt mutual funds. We now tackle the issue of whether or not debt funds are risk free.
No they are not.
No market-related investment is risk free, be it equity or debt. While debt funds are not as perilous as equity funds, they are not without their share of risks. Let’s look at them.
Credit risk
Credit risk refers to the credit worthiness of the issuer of paper-- either a corporate or financial institution. Credit risk takes into account whether the bond issuer is able to make timely interest payments and repay the principal amount on maturity.
It is wrong to assume that all debt funds take the same amount of risk, with regards to credit quality. Depending on the fund’s mandate and investment horizon, the fund manager will buy the relevant paper. For instance, Franklin India Corporate Bond Opportunities (G) has an average credit quality of A, while Franklin India Banking and PSU Debt Fund (G) has one of AAA. The latter falls in the Intermediate Bond category, while the former is a short-term bond fund.
It is also worth noting that a firm with a low credit rating often compensates investors by offering a higher return. So if the fund is delivering admirably, do check to see if the reason is due to a portfolio packed with relatively riskier instruments. It need not be the case, but do your due diligence nevertheless.
On the other hand, government bonds, being sovereign backed, have the highest rating in terms of safety.
Liquidity risk
An extension of the above is that if the fund manager invests in poorly rated paper, this could turn into a liquidity risk. A fund faces liquidity risk if the fund manager is not able to sell his paper due to lack of demand for that particular security. Liquidity risk is high in funds with a low credit quality portfolio.
Interest rate risk
The interest rate risk refers to a change in the price of a bond due to the change in the prevailing interest rate. As interest rates rise, bond prices fall and vice versa. The higher the maturity profile of a fund’s portfolio, the more prone it is to interest rate risk. So in a rising interest rate scenario, opt for funds with lower maturities. The reverse in a falling interest rate scenario.
For instance, instruments in the portfolios of liquid funds have a maturity period of less than 91 days. Hence, the interest rate risk does not exist to the tune it does in long-term debt funds. Moreover, the fund managers tend to stick to a high credit rating to maintain a very high quality portfolio which makes it less susceptible to default risk.
In India, the interest rate movements are closely aligned to the inflation scenario. In periods of high inflation, the Reserve Bank of India (RBI) hikes rates and vice-versa.
In conclusion….
Every market-related instrument has its share of risks – equity, debt, or hybrid. Granted, chances are slim that you will lose any capital in a debt fund, but neither will you make huge amounts of money. After tax and inflation are taken into account, the returns would be all the more subdued. Having said that, it is good to have a debt fund in your portfolio to help with rebalancing and park surplus cash for brief periods of time.
