Usually, Equity Mutual Funds are considered risky because of the high exposure in equities or stocks. Most investors prefer to protect their capital by investing in Debt securities. But are Debt funds really safe? The answer is no; the interest rate movements and credit quality do pose risk to Debt mutual fund investors.
Debt funds usually invest in instruments like Government bonds, corporate bond, short-term and other money-market instruments. Bond prices and interest rates move in an inverse proportion, so when interest rates rise, the prices of bonds fall. This is because investors transition to newer bonds that offer higher rates. So, the old bonds are no longer attractive, and their prices begin to dip. The opposite is true in a scenario, when the interest rate falls and the bond prices go up. Apart from interest rates, the value of your Debt fund can fall with underlying bond prices too. Bonds also indicate the ability of the company to service its principal and interest, which implies rise and fall can also be based on how the company performs financially.
Debt funds that have a substantially high exposure in corporate bonds, can be at risk, especially the one that invest in lower rated papers. Sometimes Fund Managers tend to invest in lower-rated bonds (or non AAA rated bonds) so that they can earn from high interest rates. Thus while, the yield on ten-year ‘risk-free’ Government bonds have been 7.8 percent, AAA rated corporate bonds have delivered 8.6 percent turns while the lower rated bonds given 9.2 percent to 10.9 percent returns. In a dull market, such Debt funds do better than other Debt funds that invest in Government bonds.
The problem with corporate bonds that invest in lower-rated papers, is that even though their returns are high, they pose high credit risks too. Let’s say if the fund’s holdings are such that it has more exposure in bonds rated below AAA, and the company defaults on its principal or interest payment. In such a condition, the debt fund’s portfolio to that amount, is written off. This hurts the NAV of the debt fund.
Even, if the bond does not default, the rating agencies can downgrade the ratings for these bonds, which can bring down the fund’s NAV. A case in point is the sharp dip in two Debt funds of JP Morgan, one of which had 15 percent exposure in Amtek Auto’s bonds, which were given a thumbs-down by the rating agencies.
Like Equity funds, Debt funds which have higher exposure to particular sectors can carry higher risk. Debt funds that have higher exposure to bonds issued by companies in power, infrastructure or such others, carry higher risks. If you would like to invest in Debt funds, it helps to look at the Sectoral exposure. Go for a diversified portfolio with minimal weightage to risk-prone sectors. In any case, SEBI has pruned exposure to a single sector from 30 percent to 20 percent.
While one may assume that investing in corporate bonds is risky, and investing in Government bonds is not risky at all, think again! As we said, interest movements impact bond prices. Longer duration bonds are more prone to be impacted by interest rates. If you opt for Gilt funds or Debt funds that invest only in Government securities, you need to keep an eye on rate movements. In a rising interest scenario, it is better to steer away from bonds with long duration periods.
Sometimes, Debt Funds can be far more volatile and riskier then Equity Investment. Its always recommended to be careful when selecting Debt Funds. Good quality Debt Funds selected as per right interest rate outlook can give phenomenal return as well. Its recommended to take advice from a professional and good Financial Advisor before investing in Debt Funds