Risk in Debt Funds: How to Minimise Risk in Investment
Different types of mutual fund schemes expose investors to different risks. While debt funds are traditionally considered safer for their predominant investments in fixed income securities, there are some risks in debt fund investing. Accordingly, investors must make an informed decision while making an investment decision for debt funds.
While there are broadly two risks surrounding debt funds, namely credit risk and interest rate risk, recent credit events have highlighted another investment risk within debt funds, viz. liquidity risk. Each of these risks is discussed below, along with how the fund managers mitigate such risks.
Credit risk refers to the risk of default by the issuer entity. Such risk is measured through the issuer entities' credit ratings, which incorporate the historical information and the probability of future defaults
This also explains why debt securities' valuation is severely impacted when such securities have a 'rating change,' especially a rating downgrade or when such entities default on their debt commitments. Generally, the default risk associated with G-secs, State Development Loans (SDLs), debt and money markets instruments rated AAA, A1+ etc. is lower.
Such credit risk is managed by investing in higher-rated debt securities and regularly monitoring the debt portfolio for any adverse credit events. Further, fund managers tend to have internal limits such as companies, group companies, type of investible securities, etc within the preview of SEBI Regulations.
Interest Rate Risk
Interest rate risk refers to the risk of changes in the market interest rates and consequent changes in the portfolio valuation. Such interest rates change due to any announcements made by RBI on monetary policy or any other action taken by RBI or government which impacts the benchmark interest rate, outlook on inflation etc.
As the interest rates become lower, the demand for debt securities issued at higher coupon rates increases, and such securities trade at a premium. The valuation of such debt securities increases, resulting in additional returns for the investors. Thus, there is an inverse relationship between interest rate and price of the bond. As interest rates rise bond prices fall, and vice versa. The impact of interest rate change on price of bond also depends upon the remaining maturity of debt securities. Longer duration bonds generally are more price sensitivity to interest rate changes compared to short duration bond.
The fund manager manages the interest rate risk by managing the fund duration. (Explain duration.)
Liquidity risk refers to the risk of not being able to liquidate the investments at fair value as and when the need arises. Such circumstances can arise due to the lower demand/ decrease in demand due to adverse changes to specific issuers/ group.
Liquidity risk is managed by maintaining higher-rated securities for better liquidity, maintaining a liquid portfolio, and maintaining a diversified portfolio to maintain an optimum balance between the risk and returns.
Investors can maintain their debt allocation by investing across different debt schemes and manage their investment risks accordingly.