Are Your Debt Fund Risk Free?



Lately one of the clients asked me to switch his portfolio from equity dominancy to debt. Though his reaction was obvious as the equity market has been hyperactive recently. Though after good discussion it was concluded that the client wasn't much comfortable with the fluctuation of the equity market. Hence, his portfolio allocation has to be rebalanced as per his risk appetite.

What was more important here was to get the client's expectation right regarding the debt fund and risk associated with them. Most of the time investors come with the notion that debt funds are risk-free and it becomes important to clear this could of at the very beginning that nothing in the market is risk-free. Every asset class carries some risk along with it and as an investor one should be clear about the risk and return profile of the asset class.

So in this article let us look at the key risk associated with the debt funds.

1. Credit risk in Debt Funds: 

One of the most obvious but imperative risks is the risk of default. in the recent scenarios, it is important to pay proper attention to the credit ratings and default risks of the underlying securities of the fund. 

Many times the issuer of the bonds makes default in repayments of principal amount on the maturity of the bond or the interest amount accrued on the borrowed money. This will result in a loss. Even if you have invested in debt mutual funds that have invested in bonds and there is a default in payment, your investment will lose value. Even reduce in rating will impact your NAV. 

Though with the increase in recent credit events the regulatory norms and the proactive consensus of the fund managers have made the debt funds more conscious about the credit ratings of the securities.  

Though usually, low rating means higher returns but it comes with higher risk. If you don't want to take the risk then you should invest in high rated securities. However, recent events have shown that even the high rating of the securities doesn't guarantee the credibility of the fund.  

What should you do to reduce the credit risk? 
Check the credit rating of the securities that your mutual fund invest in. Check the quality of the portfolio and fund management of the mutual fund scheme that you invest in. To be even surer keep a track on the underlying security on a periodical basis. Also, keep an eye on the concentration or high allocation of the invested amount in a particular security or company and if there is high allocation make sure the company is worthy and capable to manage its affairs to manage that high allocation.

If the allocation is unreasonably high in the particular company avoid the fund. No matter how good the company is.

2. Interest Rate Risk: 

The interest rate movements affect the performance of the debt funds. It the interest rates go up, the returns of the portfolio will be lower. For example, if a fund invests in 5-year bond which gives a return of 6 % p.a. and after 3 years there is a hike in the interest rates and bonds are offered at 8% now. Then the fund is stuck with the lower interest rate bonds and the value of your bond will also go down. 

Hence, if the interest rates go up the NAV of the fund invested in the above-mentioned bonds will go down. If the interest rate goes down funds with longer duration can generate better returns.
What should you do to reduce the Interest rate risk?
Interest rate risk is a systematic risk hence can't be avoided completely. However, it can be reduced by keeping a check on the interest rate movements in the economy or investing in the longer duration funds with the expectation of higher return in long terms on reversals of the interest rate cycles. 

Diversifying the debt investments among the various duration funds can help tackle the interest rate risk and balance the risk of your overall portfolio.

3.Liquidity Risk:

The bond market has always been lest active as compared to the equity market. Hence, it makes difficult for the fund manager to sell its underline securities in the secondary market. This can affect the liquidity position of investors. This problem increases if the fund concerned security is of a distressed or defaulted company. 


What should you do to reduce the liquidity risk?
Diversify your portfolio among the debt funds of various durations. Look for the funds which have a well-diversified portfolio. 


Addon tip: One of the key strategies for risk-averse and passive investors is to opt for hybrid funds. As in the case of the hybrid funds, the fund managers make all the required changes of shifting from one asset class to another or shifting from one duration bond to another. 


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Comments

  1. Phani KumarMarch 18, 2020 at 2:29 PM

    Hey, Thanks for sharing this Tips About Financial Planning. I just see your blog and impressed. keep the same alltime. I also fallow Analyst Ambareesh Baliga.

    ReplyDelete

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