What are the Different Risks Involved in Debt Funds?

Last Updated : June 16, 2020, 6:14 p.m.

Debt funds are those funds that invest in money market instruments, government securities and corporate bonds. Companies borrow money in the debt markets and issue bonds that carry a coupon or interest which is paid to the lender-these instruments are called corporate bonds and commercial papers. Similarly, the government also borrows through the debt markets and these securities are called government securities. Debt funds form a majority of the AUM, or assets managed by the mutual fund industry. Companies as well as individuals invest in debt funds for a period of 1 day to 10 years.

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From a layman’s perspective, debt funds are construed as risk-free, this is because of the lack of awareness about debt funds. Many invest in debt funds considering their capital to be protected like money lying in a savings a/c or a fixed deposit. This is not entirely true, there are different risks involved in debt funds that should be understood before investing. However, these risks do not put forth a case for not investing in debt funds, if one invests before understanding these risks and follows his/her asset allocation, these risks can be mitigated. There are three kinds of risks involved in debt funds, let us understand these.

Risks Involved in Debt Funds

Credit Risk

Debt funds lend money to companies, banks, and the government. Banks and the government have a higher credit profile than companies and money lent to these is considered safe, there could be an exception if a bank or a government goes bankrupt but that is very rare. The highest risk accrues from private companies, time and again there have been instances when companies have defaulted in paying back. This probability of default by a company is called credit risk. Of late, we have had companies such as ADAG group, Essel, IL&FS, DHFL, Vodafone, etc, which have defaulted on payments leading to a credit default and loss of NAV or returns for debt funds holding these securities. Some mutual funds with the aim of generating higher returns have lent to companies with low credit profiles which have led to such events. As an investor, it is important to analyze the debt fund portfolio before investing.

Liquidity Risk

Securities in debt funds are traded daily in the debt markets. You can consider it like equity shares, which have a daily price and are traded daily. The only difference is that in an equity share you can view the price whenever you wish to but debt securities are largely traded by institutions such as companies, government, banks and mutual funds because of which daily change in prices is not known to an individual. There are certain securities which would have less liquidity as compared to others or there could be an economic environment where the liquidity of debt securities decreases. In both instances, mutual funds are unable to sell these securities and repay investors. This is known as liquidity risk. Mostly, this risk arises due to a bad economic environment where the overall liquidity reduces.

Interest Rate Risk

This is one of the most prevalent risks involved in debt funds and needs to be understood well before investing. Interest rates and bond prices are inversely proportional to each other. When interest rates increase bond prices decrease and vice-versa. In a falling interest rate environment with bond prices going up, funds with the highest duration do well. So, if a fund manager buys bonds with a long duration assuming interest rates will go down, but interest rates go up his bet goes wrong, and such a fund will deliver low or negative returns. This is known as an interest rate risk. Let us understand better with an example. There is a Fund A whose duration is 10 years and interest rates decrease by 0.50%, this will lead to an increase in the bond price by 5% (10 * 0.5) or the NAV of that fund will increase by this proportion. On the other hand, if the interest rates decrease by 0.50%, this fund will give a negative 5% return.

However, not all debt funds have all these three risks, there are 16 categories or types of debt funds. Let us understand which of them carries any or all these risks.

Conclusion

Debt funds as a category have grown manifold over the years but, of late, there has been a disappointment due to lower returns in some categories and defaults. However, there are categories of debt funds and individual schemes which have performed splendidly over the last three years. Many funds in the short to long duration and gilt have delivered double-digit returns in the last couple of years. On the other hand, credit risk funds have eroded wealth, and in some funds, there have been liquidity issues as well. It is important to not paint the entire debt fund category with the same brush. We strongly recommend having debt funds be a part of your portfolio but the funds to invest should be decided after evaluating the risks involved and your investment objective.