Is there a risk in Debt Mutual Funds?

There is a lot of misunderstanding among the investors regarding the safety of debt instruments as an investment opportunity and many consider it as safe as fixed deposits if not more unaware about the risks in debt mutual funds.

Many intermediaries in the market promote debt funds in a similar way to investors.

In this article, we will try to understand the risks involved in the debt mutual funds and the various debt mutual funds instruments available and also understand the risk-reward ratio of these funds.

Are Debt mutual funds risk free?

The answer to this is plain and simple – Even debt is risky and can give negative return hence there are risks in debt bonds and mutual funds,.

But the degree of risk is lower as compared to Equity as an asset class.

When we talk about debt or debt mutual funds one has to understand the concept of debt.

What is a debt mutual fund?

When any company or any entity wants to borrow money from the market but doesn’t want to dilute its ownership (equity) it borrows money in the form of debt (bonds).

One simple example is bank Fixed Deposit.

Through a bank fixed deposit bank accepts the money from an investor (borrowed money) and promises to pay certain interest on that (interest on the borrowed money) and uses the money to lend it to other businesses.

Two important concepts

  1. For a normal understanding we can define an asset as anything that has price.
  2. And any asset that can be bought or sold in the market can give a price gain or loss both.

For example – Car (it has price, hence asset) can be bought and sold (hence can give price gain/loss) – but it will give price loss (depreciating asset).

Some other examples of depreciating assets are electronic items, furniture etc.

On the contrary real estate, gold etc are appreciating assets in nature since their value can increase with time (though they show volatility in their price).

Applying the same logic we can infer that assets that cannot be traded (bought and sold in the secondary market) such as fixed deposit it’s a financial asset (it has a price) and it’s a non-tradable instrument hence there is no risk.

A debt mutual fund is a collection of various debt bonds and debt securities that are aligned with the objective of the fund.

Debt mutual funds have below mentioned risks –

1. Liquidity risk

The bonds/securities in the mutual funds should be liquid in nature so that when an investor is willing to sell his units the bonds can be sold and the money is paid back.

There are some debt mutual funds which are not that liquid in the secondary market hence getting the money back at the time of need can be very challenging.

For example, Capital Protection Funds (debt-oriented hybrid funds with 80% exposure to debt and 20% into equity) come with a lock-in of fixed tenure, usually 3 years or more.

Though these instruments can be traded in the secondary market the demand is very less and since there are almost negligible buyers hence these is highly illiquid.

2. Reinvestment Risk

Let us understand this with an example – During 2008 the interest rates on fixed deposits were higher (10.5% for 1000 days deposits and 9.25% for 8 to 10 years deposits).

If there was an investor who didn’t needed the money for 10 years and has done the fixed deposit for a tenure of 10 year he would have got that yield even today (2018) when the interest rates have come down to a paltry 6.5%.

SBI Fixed deposit rates

Historical Fixed Deposit Rates

Source – sbi.co.in (SBI fixed deposit interest rate)

But as an investor, we have a tendency to do these deposits for 1 year on an auto-renewal mode, and also due to lack of understanding or lack of right guidance we don’t have a viewpoint on an interest rate movement.

So the fixed deposit which has recently matured (since it matures every year) is now facing a risk to be re invested at a lesser prevailing interest rate – this risk is technically called reinvestment risk.

The same analogy can be drawn in respect of debt mutual funds.

For example in the case of short-duration funds (with a duration of 6 months to 1.5 years), the bonds held in the funds keep on maturing at these intervals.

In the economy where the interest rate is declining the fund manager is facing the risk of reinvesting the maturity amount at a lower current prevalent rate.

3. Credit risk

The bonds which are constituents of debt mutual funds are rated for their quality as per SEBI guidelines by various rating agencies like CRISL, ICRA, CARE etc and depending upon the ratings are the safety of the bonds as well as yield.

For example, an AAA+ (highest rated) bond is the safest bond with lesser chances of a default hence the lesser interest rate on offer whereas a BB- (lowest rated bond) has the highest chance of default hence it offers a higher yield( premium for its lower credit quality).

The kind of risk associated with the credit quality of a bond is not only associated with the default of the bond rather there is also a possibility of a downgrade or upgrade of the bond rating.

A fund manager buys a low rated bond with the possibility of the bond being upgraded and hence providing an upside to the investor whereas in case the bond is downgraded the investor faces the risk of yield for that bond going down due to the downgrade.

4. Interest rate risk

This is the most important type of risk.

 Interest rate risk measures the price movement of bonds with respect to change in interest rates. The price of the bond is inversely related to the change in interest rate.

Price sensitivity of bonds

For a bond whose modified duration is 5 years a decrease of 0.5% in the interest rate will increase the price of the bond by 2.5% (5 *0.5%) and vice versa . Hence it is very important as an investor to be aware about these risks while investing in debt mutual funds.

Categorization and Rationalization of Mutual funds

SEBI in its recent circular of Categorization and Rationalization of Mutual funds has classified Debt Mutual Funds in 16 categories –

SEBI classification of Debt Mutual Funds

SEBI Re categorization of Debt Mutual Funds

 

SEBI Recategorization of Debt Mutual Funds

SEBI re classification of Debt Mutual Funds

For a better understanding of the risks in mutual funds an investor can refer to the categorization of debt funds.

For example, Long Duration Funds (S.No. 9 in the above table) invest in debt and money market instruments with a Macaulay duration of greater than seven years which means that the investor is exposed to the risk of fluctuation of returns of long duration.

An increase of 0.5 % in the yield will bring a decrease the price of the bond by 3.5% (0.5 * 7) and hence a higher risk as compared to the fund with lower duration.

The risks involved in these funds are shown in the figure below –

Degree of Risk in Debt Mutual Funds

As one can easily see the degree of risk is lowest in the Liquid category of funds which are used for very short term parking of funds, emergency or contingency funds whereas a Gilt Fund with 10year constant maturity or a Floater fund has a very high degree of risk.

Negative Return in Debt Mutual Fund

The picture above clearly shows that the guilt funds have given negative returns over a period of 1 year and even for a period of 6 months.

Whereas the table below shows the returns in dynamic bond funds which are either flat or negative over 1 year time period.

Dynamic Bond Fund Return

Hence, a prudent investor is aware about the risks involved in Debt mutual funds and constructs the portfolio accordingly.