Thinking of investing in debt funds? Key risks and precautions you must know

Investing in a debt fund is perceived to be simple, but it is not so really. It is more complex and equally risky to invest in debt funds. In this article, I will discuss various types of risks involved in investing in debt funds and what precautions to take 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 involved when it comes to investing in any debt mutual fund scheme.

Interest rate risk: The interest rates follow their own cycle. So when the interest rate goes up, the yield on existing investments comes down. This brings down the price of the underlying security and results in the Net Asset Value (NAV) of the scheme going down. Inversely price of the underlying security and the NAV go up when the interest rate comes down. The extent of change in the market value of the underlying security and NAV depends on the average maturity period of the underlying instruments. The longer the average maturity period higher the impact on the market value and NAV.

So, in case your investment horizon is one year and you invest in income funds having a longer average maturity period, any small increase in the market interest rate will significantly negatively affect your return, and sometimes it may generate negative returns depending on the extent of change in rates. 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, and 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 investment irreversibly. So you should assess the 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 map your goal distance with the average maturity of the debt fund you intend to invest in. If your goal is just six months away, it is imprudent to invest in any income 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 the composition of the portfolio of the scheme to avoid the risk of concentration and monitor it continuously after making the investment.

Rating of the instruments: You should also examine the ratings of the underlying securities of the portfolio of the scheme. You should invest in the schemes having substantial investments in highly rated instruments, preferably “AAA” or “AA” rated securities. 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: People invest in a debt fund with the expectation of higher returns without appreciating that higher returns come with higher risks. Have realistic expectations of returns.

Do not base your investment decision on past performance: The past performance of any debt fund scheme 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 @jainbalwant his X handle.