Debt Mutual fund investments are typically considered and positioned as one of the safe avenues for returns and parking money, but the recent incidents have proven that one has to be careful while choosing the right kind of debt mutual funds. It is important to understand the underlying risks that the investors are subjected to by the fund.
Let us understand the type of debt funds and the basis for their returns under a risk-reward paradigm. Debt mutual funds buy bonds. “A bond is a loan taken by a borrower from investors”, in exchange the company pays Interest at predetermined intervals.
Debt mutual funds that hold these bonds apply multiple strategies to provide returns to investors. These strategies rely on one of the following market element to manage their funds
Depending on the strategy of the fund or the fund manager there are three types of risks that the investments are subject to, these are given below.
- Interest rate risk
Interest rates share an inverse relationship with bonds, so when rates rise, bond prices tend to fall and vice versa.
For example, say an investor buys a ten-year bond with a 7% coupon. Interest rates rise to 8%. The investor will have trouble selling the bond as the newer bond offerings are with more attractive rates. On the contrary if interest rates drop to 6% then these bonds hold more value.
- Prepayment risk
Prepayment risk is the risk that a given bond issue will be paid off earlier than expected, normally through a call provision.
Corporates issue bonds with a call option which means they can call back the bond after a certain period. In general if there is a fall in the interest rate the corporate exercise the option. Risks to the investor,
- Investors expected cash flows will stop.
- Reinvestment risk i.e investor will have to invest the money at lower rates.
- Credit / default risk
Credit or default risk is the risk that interest and principal payments due on the obligation will not be made as required.
Depending on the Growth, interest rate cycle, current account deficit, liquidity in the market, global outlook, inflation one can assess which of these three risk taking avenues can be rewarding. Funds can assess which of these three risk taking avenues can be rewarding for their investors. Thus, these risks are then translated into investment strategies by the investment managers . The debt funds strategies are largely in three categories Duration, Interest Rate and credit risk .
Duration of the bond is important because it acts as a guide for the sensitivity of bonds towards changes in interest rates.Duration is measured in years. The higher the duration of a bond or a bond fund, the more its price will rise as interest rates drop and vice versa.
Bonds pay interest rate, if RBI reduces interest rates, the bond’s interest rates / returns become more attractive, likewise, if RBI raises interest rates, investors will no longer prefer the lower fixed interest rate / returns paid by a bond, and their price will fall.
In recent times Credit-risk funds are gaining popularity, these are a type of debt funds that invest in less than AA-rated paper. By taking greater credit risk and investing in lower-rated papers, they produce marginally higher returns.
Conditions which led to the downfall of credit risk strategy
- Defaults by the corporates due to liquidity crunch and adverse business environment.
- The current uncertain economic situation post outbreak of Covid-19 made investors risk averse.
- Investors want to play safe and do not want to buy low rated or unrated paper.
- Investments in the debt funds are dominated by FPIs,corporate and HNIs, due to Covid-19 lockdown most of the corporate facing liquidity issues therefore they are redeeming aggressively out of debt funds to meet their cash requirements.
- In March alone FPI withdrew 65,000 crores from the debt markets creating pressure on the debt funds.
Steps to be taken by the investors
Exposure to risk has to be diversified among multiple asset classes. The first action to be taken is to build a good risk adjusted portfolio with exposure to equity and debt. Second, Redeeming the investments from the debt instruments and exiting completely is not the solution, as it will affect the balance of the portfolio with increased exposure towards equities.
Our opinion here is to avoid unnecessary risk and stick to mutual funds with better credit quality. Check for red flags like investments in lower rated papers and avoid schemes with high risk. Investors should also stop chasing just returns without having regards to the risk taken by the respective schemes.
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