Even though it may seem unbelievable at first, it is a fact that investment in Debt Mutual funds has some risks associated with them. To understand these risks better, let us first understand what the meaning of Debt Funds is.
Debt funds are Mutual funds that invest in low-risk instruments such as treasury bills, corporate bonds, money market instruments, and government securities. These instruments are ideal for investors with a low-risk appetite and looking for a fixed return on their investment. The low-risk factor of the Debt mutual funds comes from the debt instruments that are not affected by market volatility.
Even though the investment in Debt funds seems safe, certain risks must be understood before investing in Debt Funds.
1. Credit Risk
• Credit rating agencies such as CRISIL, CARE, ICRA, etch rate various bonds, according to the guidelines laid by the Securities and Exchange Board of India (SEBI). These bonds, which are an integral component of Debt Mutual Funds, are rated based on their quality, which further determines their performance yield and safety.
• The highest-rated bond with an AAA+ rating offers the highest safety with low chances of non-payment. The interest rate on these bonds is less owing to its high score. On the other hand, a relationship with a low rating of BB- has the maximum chances of default and high yield.
The risk linked to the credit rating of a bond does not refer to the non-payment capacity of the relationship alone; instead, it also includes the possibility of upgrading or downgrading the current rating of the bond.
• An increase in the credit risk of a bond leads to a rise in the expectancy of the returns linked to the relationship. Therefore, If a debt fund comes with a claim of high performance, it is advisable to check the credit risk of that bond.
• The credit ratings of a debt fund keep changing over time based on the periodic risk assessment carried out for measuring the performance of the companies. The risk, therefore, that worries a fund manager is a possibility of downgrading the credit rating of the bond, and not the risk of non-payment.
Most fund managers purchase a low rated bond with the expectation of the credit rating getting upgraded and thereby leading to high yield to the investor. If the credit ratings of a relationship are downgraded, the investor bears the risk of a low return as a result of the rating downgrade. However, if the credit rating of the bonds gets upgraded, the investors would be benefitted from an improved fund value.
2. Interest Rate Risk
• The Interest Rate Risk is the most important risk associated with debt funds. It measures the movement of the bond price in response to the changes in interest rates.
The changes in the interest rate and price of a bond are inversely related to each other. An increase in one leads to the proportionate decrease in the other.
Change in the bond price = 1/(change in interest rate*modified duration of the bond)
For instance, if the difference in interest rate is 0.5% and modified Duration is 5years, the change in the bond price would be 2.5% (0.5%*5)
• The changes in the interest rate and market price of the bond vary inversely to each other. An increase in the market price would lead to a fall in the interest rate and vice versa.
Role of Modified Duration in measuring the risk of the interest rate:
Modified Duration is used to evaluate the changes in bond prices with a given change in the interest rate. Put, Modified Duration provides us with the quantum by which the bond price would change with a change in interest rate. For debt funds having a longer duration, the fund volatility is observed to be high. Among the debt funds, Bond funds and Gilt Funds have the highest interest rate risk.
It is thus advisable to consider all possible risks before investing in a Debt fund keeping aside the ignorant impression that Debt Funds are risk-free. Or feel free to contact us for any consultation related to mutual fund investment.