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Interest rate, credit and concentration risks in debt funds that you must know about

Author: Balwant Jain/Tuesday, October 1, 2019/Categories: Exclusive

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Interest rate, credit and concentration risks in debt funds that you must know about

Mutual fund products can be broadly classified into equity and debt products. A significant portion of asset under management (AMU) of mutual fund industry is represented by investment in debt funds and not equity. Debts funds generally invest their investible surplus in various instruments which bear a pre-notified rate of interest generally known as coupon rate. Learn more about the different types of debt funds and who should invest in them.

Types of debt funds

Liquid/money market funds

Liquid funds are basically money-market funds where the money is invested in instruments which are maturing within 91 days. Liquid funds invest in treasury bills and government securities and the holding period could be as low as one day. This category is like a combination of a saving bank account and a fixed deposit. One can invest money for periods as short as one day as well as for as long as months and years. They are better option for individuals who keep their money in saving bank account as these give returns more than saving bank account and almost equal to fixed deposit with added benefit of flexibility to withdraw the money partially without incurring any monetary penalty in the form of exit loads. The liquid funds will have exit load after April 1, 2020, if redeemed before seven days. One variant of liquid fund called overnight funds which are ideal for individuals as well as corporate to park their funds for seven days or less as there is no exit load and where they can park their extra cash. Returns on these funds do not fluctuate much but change in tandem with interest rates on fixed deposits.

Short and ultra-short-term debt funds

These funds are invested by the scheme in debt instruments with average maturity ranging from 1 to 3 years. For a conservative investors or an investor, who has small time horizon and cannot invest in equity fund, can invest in these funds. Since the maturity of the underlying instrument does not exceed three years, these schemes are less volatile in terms of returns generated.

Dynamic bond funds

These are the funds which are actively managed by fund managers in order to maximise the returns for the investors by continuously monitoring and switching of the portfolio depending on the interest rate conditions in the market. The investments are primarily made in corporate bonds.

Income funds

These funds are a combination of corporate bonds, government securities and money market instruments. The time horizon of their investments is generally more than three years. Since the tenure of the underlying instruments is longer they are more volatile in the times of interest rate fluctuations. They are riskier than other debt schemes and therefore are also able to generate higher returns depending on the phase of the interest rate cycle. The fund manager tries to time the entry and exit from their investments to maximize the returns based on change in interest rate cycle. Though in the long run they generate better returns but in short term, you may experience negative returns in this category due to fluctuations in interest rates.

Gilt funds

Gild funds are the one variant of debt funds where the fund houses invest the funds in government securities of various maturities. Since the probability of government defaulting in its interest and repayment liability is almost negligible, these schemes are considered safest. However, since the Gilt schemes invest in securities of various maturities, these funds carry the risk of volatility due to interest rate movements depending on the average maturity of the underlying securities.

Credit opportunities funds

These are schemes where the fund manager invests the money in the bonds of companies which are paying little higher than the better rated companies and thus are little more risky. Since the anticipated returns are higher than the other category like Gilt funds, the risk this category of schemes carries is also higher.

Fixed maturity plans (FMP)

FMPs are a category of debt funds where the investments are locked for a certain fixed period. The investment in FMP can only be made during the initial offer period. These FMPs in turn invest the funds collected in corporate or government bonds. The duration of the scheme is fixed at the time of the subscription of the scheme which remains open for a few days. The underlying security in which the fund house in turn invests is matched with the tenure of the FMP.

Risks In Debt Fund Schemes

The debt funds schemes are normally not as volatile as the equity fund schemes but still they are carry some risks generally ignored by investors. Any investment involves some sort of risk. If you invest in safe products, you carry the risk of twin ghost of “inflation and tax” eating into your returns. The investments in debt funds carry several risks. Let us understand the risks associated with investing in debt mutual funds. These are basically three risks when it comes to investing in any debt mutual fund scheme.

Interest rate risk: Since all the underlying instruments have a stated coupon rate or has an in built rate of return at the time of investment. The interest rates follow their own cycle. So when the interest rate goes up the anticipated return, based on the investments already made, goes down as compared to the market rate. This brings down the market value of the underlying investments as well as the Net Asset Value of the units of the scheme. The NAV and prices go up and when the interest rates go down. The extent of change in the market value of the underlying security and NAV of scheme depends on the average maturity of the underlying instruments. Longer the average maturity higher is the impact on the market value and NAV. So in case your investment horizon is one year and you invest in income funds, any small reduction in interest rate will significantly affect your return and you may sometimes get negative returns depending on the extent of change in interest rates. Since it is difficult for investors to get correct sense of interest rate regime which requires skills and involves risks, it is advisable for an average investor to invest with funds with lower average maturity.

Credit Risk/default risk: It was unthinkable for average investors to associate any major risk with investing in debt funds in the past except those arising from interest rate cycle. However, recent events have reversed that perception. There is enough evidence that the debt funds are equally risky. This risk majorly is due to default by some corporates in meeting their maturity liability of the instruments. The risk of default on payment of interest and on maturity is known as the credit/default risk. As compared to interest rate risk, the credit/default risk is a major risk and can even wipe out significant value of your investments. Such risk is absent in the case of gilt funds. It is almost negligible in case of liquid fund but is very high in the case of debt funds schemes like credit opportunity funds, dynamic bond funds and income funds.

Concentration risk: This is the risk of keeping all your eggs not in one basket but keeping them in a few baskets. A company may be reputed and good but there is always a risk of putting bets on only a few companies by the fund house as defaults by any of these companies will wipe out significant portion of your investments. So, while investing in debt mutual funds, you have to assess the concentration of investments by the scheme in the instruments of a few companies or groups.

Key points that investors should keep in mind

While investing in debt mutual funds you need to keep the following things in your mind.

Select the scheme as per your financial goal: As discussed above, your investment horizon should match with the average maturity of the scheme in which you are investing, failing which you carry the risk arising out of interest rate cycle. So first determine the time horizon of your goal and based on the time period of your goal, select the debt fund. If your goal is just six months away, it is imprudent to invest in any income fund. Similarly, you should identify the category of debt schemes on the basis of your investment objective and risk profile which matches with the importance and flexibility of your impending goal.

Examine and continuously monitor the portfolio of the scheme to avoid concentration: Before making your investments in a debt fund scheme, you should examine the composition of the portfolio of the scheme to avoid the risk of concentration. It is important that the concentration aspect should be regularly monitored to evaluate any change in the composition of portfolio of the scheme.

Rating of the instruments: You should examine the ratings of the instruments in the portfolio. You should invest in the schemes which have substantial investments in highly rated instruments preferably “AAA” or “AA” rated securities. Based on recent experience a highly rated instrument can overnight slip under the default category so you will still be subjected to loss of the capital in the event of such thing happening. However, if you have ensured that there is no concentration of investments in one entity or a group as discussed, the extent of loss would be minimal.

Don’t chase high returns: The turmoil in the past few months certainly has given a warning to the investors who aim for high returns without risks associated with investing in debt schemes. You should invest in the debt funds based on your risk profile and your own investment horizon. Make a realistic assessment of your ground realities and take the investment decision accordingly.

Past imperfect, future can be bright: The past performance of a debt fund scheme is not an indication of the expected returns which a particular category of scheme will generate. The past returns might have been generated under different interest rate cycles which might have reversed by now. So try to first understand the reasons behind better returns generated in the past and evaluate whether the same reasons exist even today and are also likely persist in future and the take the decision accordingly. (The writer is a tax and investment expert and can be reached at and @jainbalwant on his twitter handle)



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