Sign In

This is to inform you that scheme names have been changed for Nippon India ETFs with effect from 1st July 2022, for more details click on the Addendum. Thank you for your patronage!

 Content Editor

WHAT ARE THE RISKS ASSOCIATED WITH DEBT FUNDS?

You may have often heard that the risk in debt funds is negligible, but that is not true. Can any investment, for that matter, be absolutely risk-free? We doubt it. It is just that the degree and nature of risks vary. Just because an investment doesn’t dabble primarily in stocks, doesn’t make it risk-free. Having said that, the risk of debt funds is relatively lesser than that of equity. To understand the nature of these risks, let us first understand how debt funds work.

Why are there risks associated with debt mutual funds?

When you buy a unit of a debt fund, it implies that you have lent money to either the Government or a corporate. Here’s how. When these bodies are in need of money, they issue bonds and other fixed-income instruments with a fixed maturity period and a fixed interest rate. These securities are bought by investors like you, and the money you pay is used by these bodies to meet their short- or long-term liquidity requirements.

These bonds are then either held till maturity or traded in the market as per fund manager decision & in line with the investment objective of the fund. Now, like any other lending/borrowing transaction, even a debt fund purchase can carry risks. Because at the end, it is an interest-bearing security which is being traded in the market. There are micro/macro-economic factors affecting the debt funds, the interest rate fluctuations, the possibilities of the abovesaid bodies not being able to repay the loans or the securities losing liquidity in the market for buying/selling. Factors can be many, but what you need to look at, as an investor, is whether the risk-reward ratio working for you, i.e. whether the risk of debt funds is worth the returns you will get. Also, of course, it should match your risk appetite as well.

What are the risks of debt funds?

Interest rate risk

This risk is due to the negative correlation between the interest rate and the bond price in the market. When the interest rate goes up, the price comes down and vice versa. It is also dependent on the maturity period of the bond. The longer the maturity period, the more exposure your bond has to the interest rate fluctuation. Hence, low duration debt funds are considered to be low risk debt mutual funds.

For example, let’s assume that you are invested in a bond that has maturity of 10 years and offers an interest of 10%. Now if you invest Rs 10,000 in it, ideally you will receive Rs 1000 at the end of every year till 10 years, and in the last year, you shall get your principal amount of Rs 10,000 back. That is how the bonds work. But now, consider the interest rate falling to 8%. Now, since your bond offers a higher interest rate of 10%, the demand for it increases and hence, the bond price increases too. In this case, you will have to spend more to buy the same number of units. You see, this is the risk you face in terms of the interest rate fluctuations in the market since your securities are being constantly traded

Credit risk

Never forget that you are lending someone your money. After all, and there is always a possibility of them not being able to return the money. This risk associated with the credit repayment capability of the body you are lending to is called the credit risk. This ability is determined by a measure called ‘credit rating’, and there are credit rating agencies like CRISIL, ICRA, etc. who rate this ability. Higher the credit rating, higher is the ability to pay, and safer is your investment. Understand credit ratings better Here

The thing to keep in mind here is that the credit ratings can also change over a period of time. If this happens, the value of the debt securities that the fund manager is holding also comes down, and it can impact the fund adversely.

Liquidity risk

If the securities held in your mutual fund portfolio are not frequently traded or if their demand is lesser, then the fund manager may be forced to sell these securities at a loss if the intent is to sell them before their maturity.

What can your approach to these risks be like?

Should you stop investing in the debt funds? Of course not! That is, if they align with your investment objectives. The probability of the occurrence of these risks plays an important part in the kind of returns you will make. And the risk that you ultimately undertake in any kind of investment must be calculated. For example, most investors know that equity mutual funds are much riskier than debt mutual funds. But has everyone stopped investing in the former? No. It is because an increase in risk also brings in the possibility of increased returns.

If you look at the benefits that you can derive by investing in debt funds, they may just surpass the risk of debt funds. For example, features of debt funds such as their liquidity, the indexation benefit on the long-term capital gains tax on debt funds, the ability to produce relatively stable returns as compared to equity or even just the opportunity to be able to invest in a market that may otherwise not be available for your to invest in- are options worth considering! Know more about the benefits of debt mutual funds Here

The information herein is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. The document has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. The sponsor, the Investment Manager, the Trustee or any of their directors, employees, associates or representatives (“entities & their associates”) do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such information. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice in order to arrive at an informed investment decision. Entities & their associates including persons involved in the preparation or issuance of this material shall not be liable in any way for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including on account of lost profits arising from the information contained in this material. Recipient alone shall be fully responsible for any decision taken on the basis of this document.

Mutual Fund Investments are subject to market risks, read all the scheme related documents carefully

Get the app