MFDs/advisors often ask their risk averse investors to put their money in debt mutual funds. The reason is simple — debt funds are relatively low risk instruments that help bring in stability and diversification to a portfolio.
Debt funds may be safer than equity funds but are not immune to risks. They face risks such as credit risk, interest rate risk and inflation risk. It’s important for MFDs/advisors to take these risks into consideration before recommending debt funds to their clients.
In this article, we will take a look at the two major risks that debt funds face - credit risk and interest rate risk.
Credit risk
Let's use an example to understand things better.
A friend asks you for a Rs 20 lakh loan to expand his business. He promises to pay 6% interest every year. As the interest rate offered by your friend is higher than bank FDs, you decide to lend money to your friend.
But the investment comes at a risk. With businesses, there's always a chance of default and if that happens your investment will surely suffer. If your friend’s business plan doesn’t work, he may not able to honour his commitment of paying interest. In fact, he may face difficulty in paying the principal back on time. This is called credit risk.
Debt funds face credit risk as they are effectively lending money, much like you in the above example.
What is credit risk?
Credit risk, also known as default risk, is defined as the chances that a borrower might fail to repay the interest or principle on the committed date.
Not a grave threat
The risk differs from fund to fund. You can gauge the risk by going through the ratings of the constituents of the fund. There are various rating agencies like CRISIL, ICRA and CARE that rate bonds according to their chances of default.
For example, an AAA+ (highest rated) bond is the safest bond with least chances of a default. Bonds with BB- or lower ratings have the highest chances of default.
However, this is not something to be really worried about. Risk averse investors can go for debt funds that invest only in high-rated securities. These bonds have only a miniscule chance of default.
Interest rate risk
Debt funds do not offer fixed returns. The return they generate depend on the interest rate, which is prone to changes. Interest rates typically fall when the economy is growing and vice versa.
Bond prices and interest rates move in opposite directions. When interest rates rise, bond prices fall and vice versa.
In the above example of your friend, assume that the interest rate offered by bank FD goes up to 6.5% from 5.5%. Since you lend at 6%, the value of your existing holdings decline due to attractive rate of new debt securities.
This poses a risk to debt funds as their returns come down when interest rates go up.
What’s the solution?
This risk can be minimized by investing in funds that avoid long duration bonds. This is because price volatility is directly proportional to 'time to maturity'. Longer the maturity, greater is the price volatility.
Simply go for funds with low average maturity.
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