Most investors in India understand they shouldn’t invest in Equity Mutual Funds by solely looking at the past or recent returns of funds. But when it comes toinvesting in Debt Funds, more often than not, this is the exact thing they do. Just like in equity, this approach is quite risky in debt too. That’s because higher returns, irrespective of the type of investments, are mostly generated by taking higher risks. And if any of those risks play out, you might find yourself in a situation you are not comfortable with.
In this blog, we will tell you about the risk involved with Debt Fund and how should you pick the right Debt Fund for your portfolio.
Though Debt Mutual Funds are often touted as safer than Equity Mutual Funds, they are not completely risks. They carry two major risks.
Here are the 2 risks involved while investing in Debt Funds
#1. Interest rate risk:
Debt Funds invest in debt instruments or bonds. Just like stocks, bonds are also traded in the market on a daily basis. Their prices also move up and down, driven primarily by how interest rates are changing or how people expect them to change. Whenever the interest rates go down or people think that the interest rates are likely to go down, the bond prices go up, due to high demand.
Let’s understand this with an example. Suppose a Debt Fund holds a bond that is paying a 10 percent annual interest rate. Now, if the interest rates in the economy fall, any new bond coming into the market will give a lower interest rate, say 9 percent. And because of this, the demand for the old bond giving a higher interest rate increases. This leads to a rise in the price of the bond and, subsequently, the NAV of the Debt Fund holding it.
Similarly, if the interest rates go up, bond prices come down, because now the demand for this bond that is paying a lower interest rate decreases.
This price movement of bonds due to interest rates is called interest rate risk.
#2. Credit risk:
You may have heard of personal credit scores, like the CIBIL score, which reflects how well you have managed to repay your debt obligations like loans in the past to give you a score. In a similar manner, there are ratings for companies too. These agencies are called credit rating agencies. Companies like CRISIL, and ICRA are two examples of such agencies. These agencies look at a company’s financials and its past history to assess its debt repayment capability. And then a rating is assigned to reflect this capability. AAA is the highest rating which indicates that it’s almost certain the company will repay its debt and hence has low credit risk. Next is AA, which indicates relatively less certainty so a slightly higher credit risk and so on. This goes all the way to D. D is given when a company has not paid its loan back or it looks like it won’t be able to pay back. The best way to avoid this risk is to invest in the debt fund that lends to highly rated corporates.
Now that you know the risks, let us see how you can approach investing in Debt Funds.
To help you understand this better, we divided the most popularDebt Fundcategories into 3 distinct types. For the purpose of making it easier to understand, let’s name them –Safety-First , FD+ and Beat the FD.
Number 1: Safety-First: Debt Categories where safety of principal is the focus
Two fund categories,Overnight FundsandLiquid Fundsfall in this category. These are the safest funds in the debt category with negligible interest or credit risk. In these funds, safety and liquidity take the highest priority with returns being an outcome of the first two factors. Although they are considered a good option for keeping cash you might require immediately or for emergency needs, you can also use them for investing for longer durations too. That’s because the difference in returns between these and slightly higher risk category funds isn’t too much. Therefore, you will see a higher difference in absolute amount only if you invest a significant amount.
So if you are a conservative investor, pick one of these two fund categories for your entire debt allocation. Ideally, Overnight Funds are good for up to seven days of tenure. Meanwhile, you can consider Liquid Funds for investment horizons that are higher than a week.
Number 2: FD+ : Debt Categories that can give slightly higher than FD returns without too much risk
We are calling this FD+ not because they are an enhanced FD product but because the returns generated by these fund categories are slightly higher than what FDs of the same investing duration tend to give.
Low Duration funds,Short Term Fund,Corporate Bond Funds, andBanking and PSUfunds are the categories that constitute the FD+ Returns type of Debt Funds. These funds are low on both interest rate risk and credit risk with high credit quality bonds (AAA or equivalent) forming the majority of their portfolios.
FD+ type of Debt Funds give slightly higher returns than Safety-First Debt Funds without compromising too much on safety of your investments.
If you are looking to invest for 6 months to 1 year, you can consider low duration debt funds. For 1-3 year investment periods, all the remaining categories are ideal if you are willing to take slight risk. Among these FD+ types of Debt Funds, Banking and PSU have the least Credit Risk, followed by Corporate Bond Funds, Short Term Funds and lastly the Low Duration Funds.
Number 3: Beat the FD: Debt Funds that try to beat FD returns by taking calculated risks
Fund categories in Beat the FD are for investors seeking returns that are meaningfully higher than FDs and are okay taking a higher risk for these higher returns.Dynamic Bond Funds, Credit Risk Funds, and Debt-oriented Hybrid Fundsare categories in this.
These funds take different approaches to generate higher than FD+ type of Debt Funds. These approaches can range from taking interest rate risk or a mix of credit risk and interest rate risk to adding a small portion of Direct Equity i.e. stocks in the portfolio. Let’s look at those approaches in detail for a better understanding:
- Timing the Interest Rate approach:In this approach, the fund manager actively manages interest rate risk to fetch higher returns by timely buy and sell calls of bonds of different tenures .Dynamic Bond Fundsuse this strategy. However, for this strategy to be successful, the fund manager needs to time the interest rate cycle right. A wrong call can lead to losses.
- Credit Approach:Here, higher returns are generated primarily by investing in lower-rated instruments that offer higher yields.Credit Risk Fundsfollow this approach. While these funds have some interest rate risk, credit risk tends to be larger risk than interest. A very poor quality of portfolio or concentration of holdings in low-quality bonds means you can see losses if the underlying companies’ capability to service the loan repayment obligations is affected in a negative manner in times of economic distress or unfavorable business cycles.
- Hybrid Fund Approach:In this approach, the fund allocates 10-40 percent of its portfolio to equities to enhance the returns.Equity Savings FundsandConservative Hybrid Fundsare examples. While conservative funds allocate between 10-25 percent to equities and remaining is invested in debt. Equity Savings Funds use a mix of equity, arbitrage, and debt in almost equal proportions. Since the portfolio of these funds have equity exposure, the debt portfolio of these funds is typically low risk with high credit quality papers and bonds with lower interest rate risk.
All these categories under Beat the FD type, are ideal only if you are looking to invest for at least 3 years with an appetite for volatility in the period you stay invested.
Bottom Line:
Investment in Debt Funds should be a core part of one’s asset allocation. But before taking the decision on which fund to invest, it’s important to zero down on the right category that suits one’s risk appetite and investment horizon. It is always good to remember, Debt Funds should be more about adding stability to your portfolio and less about higher returns. With this as underlying principle, most investors would do well by restricting their investments to Safety-first and FD+ type of Debt Funds.
