Risks in Debt funds
Debt funds, which are recommended for conservative investors, are also not free from risks. The investment portfolio of these funds comprises fixed income instruments, which make periodic payouts and repay the principal amount at maturity. The value of the fixed income instruments is influenced by changes in economic indicators, such as short-term and long-term interest rates, inflation, government deficits and balance of payments. Let us consider some of the risks faced by the manager of a debt fund.
Credit risk: This is also known as the default risk and arises from the possibility that the issuer of the debt instrument may be unable to pay periodic interest or repay principal on maturity. The credit worthiness of the issuer is assessed through the ratings assigned by credit rating agencies. Generally, the lower the credit rating, the higher the credit risk, and vice versa. A fall in credit rating leads to a drop in the price of the debt instrument and this significantly impacts the fund's NAV.
Interest rate risk: The price of debt securities, especially bonds, is extremely sensitive to the movement in interest rates. The price of a bond falls as the interest rate rises, and vice versa. Therefore, the value of bond investments is adversely affected during a period of rising interest rates.
Consider that a substantial corpus of a fund is invested in a 10% coupon bond, which is purchased by the fund manager at its face value of Rs 1,000. Its price will go down to Rs 833.33 if the general level of interest rate goes up to 12%. Accordingly, this negatively affects the value of the fund.
Reinvestment risk: The varying interest rate levels in the economy give rise to such a risk. It refers to the probability that the periodic cash flow from bonds will be reinvested at a rate that is less than the coupon rate of the bond. This reduces the cumulative interest component of the bond, which, in turn, reduces the value of the fund. Consider a fund, which has invested in a 10% coupon bond that pays a half yearly interest.
The purchase price is Rs 10,000 and its term is five years. If periodic interest payments are re-invested at the coupon rate, the cumulative interest component after five years will be Rs 6,254. However, if the interest rate falls to 8% after three months (and remains constant thereafter), the cumulative interest component will plunge to Rs 5,981. This deficiency in the value of the cumulative cash flow reduces the fund's value as well as its NAV.
Marketability risk: The secondary market for debt is not fully developed in India. The transactions in the debt market are usually concentrated in very few securities. Moreover, the trading volume varies for different securities on a daily basis. These market characteristics expose the debt mutual funds to marketability risk. While transacting in debt securities, funds are exposed to a substantial impact cost (measured using bid price and offer price), which impacts the value of a fund significantly.
For minimising some of the market risks, such as interest rates and currency movements, fund managers use derivative markets for hedging their positions. Derivatives are highly specialised instruments and offer opportunities with disproportionate gains. However, they are also associated with disproportionate losses. While these securities offer strategies for reducing losses in the equity and debt markets, they are themselves not free from risks
Best Regards
Prakash Nair
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