People think that investing in equity funds is very complex, but I feel that investing in debt mutual funds is equally, if not more complex. Investing in a debt fund carries its own risks. In this article, I will discuss the various types of risks involved in investing in debt funds and what are the precautions to be taken while investing in them.
Primary risks associated with debt mutual funds
Any investment involves some degree of risk. No investment is safe. Like if you do not want to invest the money to avoid the risk and keep the money at home, you incur the risk of erosion of money due to inflation.
Likewise, if you invest in a very safe product, you carry the risk of the twin ghosts of “inflation and tax” eating into your returns. There are basically three types of risks when it comes to investing in a debt mutual fund scheme.
Interest rate risk: The interest rates follow their own cycle. When the interest rate increases, the yield on existing investments decreases. This brings down the price of the security where the debt funds have invested and thus the Net Asset Value (NAV) of the scheme.
Inversely, prices and the NAV go up when the interest rates go down. The extent of change in the market value of the underlying security and NAV depends on the average maturity of the underlying instruments. The longer the average maturity higher the impact on the market value and NAV.
Therefore, if your investment horizon is one year and you invest in income funds with a longer average maturity period, any slight increase in market interest rates will significantly negatively impact your return, and sometimes it may even generate negative returns, depending on the extent of the interest rate change.
As it is difficult for a lay investor to get a correct sense of interest rate movement in the future and which requires skills and involves risks, an average investor should invest with funds with a lower average maturity unless the investment horizon is longer and matches the average maturity of the scheme.
Credit Risk/default risk: Till the recent past, it was unthinkable for an average investor to associate any major risk with investing in debt funds except the one arising from the interest rate cycle.
However, recent events have changed that perception seriously. This risk majorly manifested itself due to default by various corporates in meeting their maturity liability of the instruments. The risk of default on interest and maturity is known as the credit/default risk.
As compared to interest rate risk, the credit/default risk is more serious and irreversible. It can even wipe out the significant value of your investments. Such risk is absent in the case of gilt funds, it is almost negligible in the case of liquid funds, but is very high in the case of debt fund schemes like credit opportunity funds, dynamic bond funds, and income funds, etc.
Concentration risk: However, a company may be reputable and good, but there is always a risk in putting all the bets on a few companies by the fund house, as default by any of these companies will wipe out a significant portion of your investments irreversibly. So you should assess and avoid the funds with a concentration of investments in the instruments of a few companies or groups.
Key points while looking at debt schemes
While investing in debt mutual funds, you need to keep the following things in mind.
Select the scheme as per your financial goals and risk profile: As discussed above, your investment horizon should match the average maturity of the scheme, failing which you carry the risk arising out of the interest rate cycle. So, based on how far your goal is, select the debt fund. If your goal is just six months away, it is imprudent to invest in any liquid fund.
Likewise, you should identify the category of debt schemes on the basis of your investment objective, your risk profile, and the importance and flexibility of your impending goal.
Examine and continuously monitor the portfolio of the scheme to avoid concentration: As discussed above, before making your investments in a debt fund scheme, you should examine and monitor its composition of portfolio of the scheme continuously to avoid the risk of concentration.
Rating of the instruments: You should also 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.
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 if any security rated high gets categorised as default.
Not to chase high returns: The turmoil a few years back certainly gave a warning to the investors who want to have the highest returns without appreciating the risk associated with investing in debt schemes. Have realistic expectations of returns.
Do not base your investment decision on past performance: Past performance is not an indication of the expected returns. The past returns might have been generated under different interest rate cycles, which might have been 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 to persist in the future, and then make the decision accordingly.
Balwant Jain is a tax and investment expert and can be reached at jainbalwant@gmail.com and on @jainbalwant his X handle.