Bond fund is a type of mutual fund that invests in bonds or other debt instruments. Different from equity funds and money funds, bond funds pay dividends periodically in the form of interest on the underlying securities as well as realized capital appreciation. Despite the fact that bonds are considered to be less volatile than equity, there are a lot of risks prevailing in bond funds ranging from interest rate to liquidity. These risks adversely impact the performance of bond funds investing in such instruments. So, you must know such risks in detail and also keep an eye on the solutions to mitigate the same.
1 Interest Rate Risk
Duration of the bond is a measure of price sensitivity of the instrument with respect to the movement in interest rates. The bond prices tend to fluctuate with the variation in interest rates when the maturity period of the instrument is longer. Let us understand the interest rate risk with the help of an example. Suppose there remains a 5-year bond with a face value of Rs 800 at the interest rate of 7% per annum in the market. Suddenly, a new bond of same period and face value with a higher interest rate of say 8% comes, then its demand will go up as investors will take it to earn more interest. While the demand for the earlier bond will go down. With the fall in demand, the price of the earlier bond will slump and the said instrument will be available at a discounted price. So, the investors, who have put their money in that bond, will suffer from capital erosion.
Inverse relationship between interest rate and bond prices
You must understand the inverse relationship between bond prices and interest rates. When interest rates rise, the old bonds are not worth much. Upon rise in interest rates, the new bonds come to market with more yields than the older securities, which then become less worth. So, their prices start to fall. When there is a decline in interest rates, new bonds are issued at lower yields than the previous ones. Therefore, the older securities tend to be worth more than the new ones during that time.
How interest rates are affected?
Interest rates are largely governed by various economic forces. When the economy grows, the interest rates start to go up. Similarly, when the economy starts to slow down, interest rates slump. When there is a spike in inflation, the interest rates will rise. When the inflation moderates, the interest rates will fall down.
2 Credit Risk
- Credit risk tells about the credit worthiness of the bond issuer.
- This type of risk factors in aspects like payment of interest as well as the face value of the bond issued by the issuer to the investors during the time of maturity. If the issuer fails to do the same, then the bond is believed to be in default. As a result, the credit rating of the bond issuer falls down and raises doubts on its credit worthiness.
- Any downgrade in credit rating will let the prices of the bond to fall, thereby adversely affecting the performance of mutual funds investing in such bonds.
- The possibilities of credit downgrades are more when the economy is going through downturn.
- Companies that take debt for their operations are susceptible to credit risks.
3 Liquidity Risk
- Bond fund faces liquidity risk if the fund manger fails to sell a specific security in the market due to less demand for the product.
- Corporate bonds are less liquid in nature compared to government bonds and money market instruments.
- The low liquidity is due to less participation of investors in corporate bonds.
- When the economy faces downturn, illiquid instruments like corporate bonds struggle to stay afloat, making bond fund investors lose their money.
- Continuous rupee depreciation can also result in liquidity risk for the bond funds. The fall in rupee value, however, may not directly impact the performance of bond funds.
How to manage risks?
- Choose a bond fund that does not change frequently with its duration
- Select a bond fund that has duration closer to your investment horizon
- Choose bond funds that may have invested in corporate bonds, which would have less exposure to credit risks.
- Find the bonds that would have performed well during the downturn of the economy
Now that you have got the details of the risks and the means to counter the same, you can choose the bond funds that can fit into your risk profile. Choosing the right bond fund will help you achieve your investment goal in the true sense.