Invest in mutual funds? Know the risks associated with debt funds

Debt mutual fund are plans that invest in fixed income instruments such as government and corporate bonds, or money market instruments such as treasury bills. They offer moderate capital appreciation and a high degree of security to investors and help them balance their portfolio for lower risk. Also known as fixed income funds, these plans are generally perceived as relatively less risky than equity-focused plans because they tend to offer stable returns. However, returns may not always be enough to beat the upside inflation.

Debt mutual funds are suitable for investors who have a low appetite for risk but want to invest in instruments that provide capital appreciation as well as capital safety. These investors may consider replacing their traditional fixed income investments in bank deposits with debt funds. However, debt schemes do not offer guaranteed returns as is the case with traditional fixed instruments such as bank deposits or post office investments. Like equity schemesdebt systems are also subject to market risks.

They may seem like simpler and more stable products than equity plans, but they also come with complex risks. Therefore, it is advised that before investing in mutual funds, you realize the risks involved. This will help you make informed decisions about your investments in debt funds. Take a look at the top four mutual fund risks:

Credit risk

The debt instruments in which the debt schemes invest have different credit ratings. A higher rating reduces the risk of default by the issuer of these instruments. On the other hand, if the rating assigned to the debt securities is low, the risks of default are higher. That said, this does not necessarily mean that lower ratings will always result in a default. Similarly, higher ratings do not guarantee that issuers will not default. Fund managers of debt schemes typically choose a combination of various such instruments to generate higher but risk-adjusted returns. In doing so, these funds still bear the risk of credit risk.

Generally, we find that there is a high interest rate among issuers whose credit rating is low. Since they need to raise funds, they tend to offer a lucrative coupon rate (interest rate) to investors. At the time of maturity of their issues, if they are in default of payment of interest or principal or both, this negatively impacts the net asset value (NAV) debt regimes. On the other hand, issuers with high and stable credit ratings do not offer high interest rates and debt schemes invest in them for stable returns.

Interest rate

It should be noted that the prices of bonds or fixed income securities are inversely proportional to the cost of borrowing or, more simply, to interest rates. This basically means that when interest rates rise, bond prices fall. And the reverse happens when interest rates rise. Since debt funds are interest rate sensitive, during periods when rates are low, debt funds tend to perform better.

Inflation and macroeconomic situation

The macroeconomic situation plays a vital role in the performance of any investment, including debt instruments. Fiscal and monetary policies have their impact on money markets which therefore have their impact on factors such as inflation, bonds and interest rates. A persistently high rate of inflation usually forces the central bank and government to take action to control it either by reducing interest rates or by taking steps to improve supply dynamics. Such interventions have an impact on debt investments.

When investment decisions go wrong

Deciding which instruments to invest in involves careful research and risk analysis. Sometimes some of the investment calls taken by the fund managers while building the portfolio of debt schemes may not yield the desired results. This may occur due to too much exposure to certain instruments that have not performed in accordance with fund managers’ expectations and research analysis. Often, when a plan makes a substantial allocation to certain instruments that unexpectedly default, the overall valuation of the plan’s portfolio is negatively affected.

Investors should understand that even debt funds, although relatively stable compared to equities, are subject to risk and it will not be fair to assume that they are completely risk free. While the last three risks are generally temporary, credit risk is permanent. However, this does not mean that you should completely ignore debt funds. As these funds are professionally managed, fund managers always strive to mitigate risk by intervening in a timely manner to ensure there is the least impact on overall valuations.

Debt funds tend to generate higher returns than traditional fixed income products. If planned well with the likely risks involved in mind, investing in mutual funds as part of your asset allocation can help you achieve your financial goals.

(Adhil Shetty is CEO of BankBazaar.com.)

(Disclaimer: The opinions expressed in this column are those of the author. The facts and opinions expressed here do not reflect the views of www.timesnownews.com.)

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