Many people think that when one invests in debt mutual funds, there is no risk associated with it. However, the meaning of risk is, deviation in actual returns from the expected returns. And that kind of deviation is possible even in debt mutual funds. Risk persists everywhere in investing. Let us understand what kinds of risks are there in debt mutual funds.
Generic risks in debt mutual funds
Unlike equity, debt securities are repayable on maturity. This factor makes debt mutual funds less risky than the equity funds. In the case of debt mutual funds, whatever the imperfections are in the market, a solvent issuer still repays the amount promised on maturity. However, despite the assured value on maturity, debt securities fluctuate in value, with changes in yield and in the overall market. The prime factor here is change in the interest rates. The interest rates in the economy are influenced by factors beyond the control of any single entity. It is the policies of the government and Reserve Bank of India (RBI) that decide the interest rates.
Though the interest rates are based on the government and RBI policies, there are certain economic factors that guide such policy decisions. Based on this, fund managers try to predict the policy decision for interest rates. If a fund manager is taking a wrong call on the direction of interest rates, it can seriously affect the performance of the debt mutual fund scheme. Thus, the impact of change in interest rates is a generic risk faced by the debt mutual funds.
While this is the case with government debt instruments, investment in non-government debt instruments has a credit risk associated with it. Credit risk also known as default risk, broadly means, the issuer may fail to make the payments as scheduled on interest and principal repayment. A fall in the credit quality will see the value of the securities declining.
One must understand that the debt market is not as vibrant and liquid as the equity market. Therefore, there is the possibility of not finding a buyer for the securities held. The liquidity risk also persists in the debt mutual funds. To simplify, when securities are not traded in the market, an element of prejudice affects the valuation and eventually the net asset value (NAV). The fund manager has to ensure the scheme is liquid to the extent that the fund has the ability to move in and out of a scheme without impacting its value or price. It is the fund manager who ensures the scheme is liquid to manage large redemptions without having an impact on the NAV of the scheme.
The Securities and Exchange Board of India (SEBI) has laid down detailed portfolio valuation guidelines to limit the risks associated with liquidity and enhance the transparency of NAV. However, some amount of liquidity risk remains in debt mutual funds.
While these are generic risks applicable to the debt mutual funds, there are certain portfolio specific risks as well. Let us understand the different portfolio specific risks.
Portfolio or scheme specific risks
If we compare the mutual funds scheme based on the time horizon. The short maturity securities suffer lesser fluctuation in value compared to the ones with longer tenure.
Short term funds basically invest in securities with maturities of less than one year. Therefore, the main focus is on generating returns through interest earned and not from the gains due to the change in the value of the securities. As a result, their returns are more stable and less volatile.
In the case of gilt schemes, investment is made only in government securities, such schemes have a higher price risk because their NAV can fluctuate a lot more. To simplify, greater the proportion of longer maturity securities in the portfolio, higher would be the fluctuation in NAV.
In the case of bond funds, there are higher possibilities of credit risks. Bond funds may take on higher credit risk by investing in lower-rated (given by credit rating agencies) instruments to earn higher coupon income or to benefit from an increase in prices if the rating eventually improves. However, such exposure to the lower credit rated instruments increases the risk of defaulters in the scheme.
In the case of fixed maturity plans (FMP), the fund managers align the maturity of their portfolio to the maturity of the scheme and hence the yield is relatively predictable. One must understand that such predictability is only on maturity when the investee company repays the principal on the securities to the scheme. In the interim, the value of such securities will fluctuate in-line with the market. As a result, the scheme’s NAV will also fluctuate. Furthermore, if the FMP is structured on the basis of investment in non-government paper, then the credit risk or default risk is an issue.
Investors usually tend to bear higher risk in few of the structured products. Being complex in nature they expect the returns also to be on the higher side. In the case of specific structures such as securitised debt, it is not possible for the investor to study the debtors whose obligations support the securitisation. Credit rating agencies that rate the securitised debt portfolio may help on the same, but to a limited extent only.
Pure capital guarantee scheme is one where the guarantee comes out of sovereign debt i.e. government securities. Such securities mature to the requisite value on the closure of the scheme. However, mutual funds schemes where the capital guarantee is based on investment in non-sovereign debt, even if it is an AAA-rated portfolio, do hold a credit risk. Therefore, the capital guarantee cannot be taken for granted in case of non-government debts.
A particularly risky category of debt funds is junk bond schemes that invest in securities of poor credit quality. SEBI regulations, however, limit the exposure that mutual fund schemes can take to unrated debt securities, and debt securities that are below investment grade.
Conclusion: Despite debt mutual funds being considered as safe investments compared to equity mutual funds, risk persists in debt mutual funds. With generic risks like interest rates and liquidity risk there are portfolio specific risks the deviation occurs from expected returns.
Pro Tip: The long maturity securities suffer higher fluctuation in value compared to the ones with shorter tenure. Invest only if the scheme holds the potential to help meet the investment objective.
