Are debt funds risk free?

By Larissa Fernand |  03-11-14 | 
 
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About the Author
Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

If you're buying a debt fund to give your portfolio stability or to help generate income, then your strategy may pay off. Investing in debt mutual funds usually entails less risk—and less reward—than investing in equity mutual funds. But debt funds, like every mutual fund, do involve some degree of investment risk.

Having said that, all debt funds cannot be painted with the same brush. Liquid funds, ultrashort, short term, intermediate, and long term are various categories that do not perform alike or carry the same risks. 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 July 2013, the net asset values, or NAVs, of liquid funds showed a negative return over a short period taking everyone by surprise. The Reserve Bank of India, or RBI, intervened in the markets very aggressively to curb currency speculation and halt the slide of the rupee. The fallout was rising short-term rates and a tight liquidity position which made liquid funds lose out on mark-to-market valuations.

Such funds conduct the accounting of returns on mark-to-market basis in the case of all papers with a residual maturity of 60 days and above. A sharp increase in overnight rates led to a fall in bond prices leading to the loss in valuation. As a result the NAV of liquid funds dropped.

There are two points investors must note about this episode. One, the drop was marginal. For instance, between July 15 and 16, the drop in NAV of liquid funds was a maximum 0.34%. Secondly, this was a one-off event that occurred due to a trigger.

  • 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.

In India, the interest rate movements are closely aligned to the inflation scenario. In periods of high inflation, the RBI hikes rates and vice-versa.

  • Credit risk

Each debt instrument is assigned a credit rating. Higher the credit rating of the fund’s underlying instruments; less exposed the fund would be to credit defaults.

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. 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. Government bonds, incidentally, are sovereign backed and have the highest rating in terms of safety.

  • Liquidity risk

Linked to the above is liquidity risk. If the fund manager invests in poorly rated paper, it 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.

No market-related investment is risk free, be it equity or debt. While debt funds are not as perilous as equity funds, these are the risks that they carry.

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