Knowing Debt Funds & the risks associated with them:
Debt Funds primarily invest in fixed income instruments of varying maturities such as Government Bonds, Debentures, Money Market Instruments, and Corporate Bonds, etc. To diversify risk, investors prefer to hold a certain proportion of their portfolio in debt funds. It is so because debt funds have the ability to generate steady income and preserve capital.
As a prudent investor you need to know the working mechanism of debt mutual funds before making an investment. This article sheds light on the intricate details of debt funds concerning its types, structure, & risk-return trade-off.
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Structure of Debt Mutual Funds
The structure of Debt funds involves employing your money either into specific or a mixture of various kinds of fixed-interest bearing securities like treasury bill, commercial paper, certificate of deposit, government bonds, etc. and generate returns. The return on investment in case of debt funds is obtained in two forms. Firstly, from regular interest at a pre-determined rate as specified on the face of the security. Secondly, by capital gains when the price of the holding instruments increases in the market. Just like equity shares, you may trade debt funds in the secondary market. Moreover, these are susceptible to price changes as a result of rising or falling interest rates in the economy.
Now you may think how are bond prices related to the interest rate regime?
There is always an inverse relationship between bond prices and interest rates. The market price of the bond falls with an increase in the interest rates in the economy and vice-versa. The phenomenon is illustrated with the help of an example. Consider a bond that pays annual interest at the rate of 9 percent. Consequent to a rise in the interest rates in the economy, another bond is issued which pays interest at the rate of 10% per annum. Now, this lowers the worth of the existing 9% bond which results in fall in the demand for the bond. Automatically, the market price and Net Asset Value of 9% bond fall in the market and the bondholders suffer a loss of return. Similarly, when interest rates fall in the economy, the price of existing debt funds increase.
Investment Strategies of Debt Mutual Funds
Before we move to different categories of debt funds, it is vital to understand how debt funds generate returns on investment. Debt funds employ two kinds of investment strategies:-
1. Hold till Maturity
It is also known as accrual strategy whereby the fund manager is more focussed on the interest generating ability of the debt fund instead of the capital gains component. He gives preference to high-interest bearing corporate bond over low-interest bearing government bonds even if it amounts to taking higher credit risk. In the rising interest rate regime, he would purchase short-term high-interest bearing bonds that would mature in 1-3 years to give him high yield on maturity. It would help him to keep a tab on losses on account of erosion in bond prices. In this way, he achieves a trade-off between high returns and high credit risk that may arise due to the purchase of low-credit-rated bonds.
2. Duration Strategy
In this strategy, the fund manager gives greater weight to capital gains component over interest generation ability of the bonds. He would monitor the interest rate regime and adjust the duration of his portfolio to maximise his return. He is less focussed on high-interest bearing corporate bond scrips that attract correspondingly higher credit risk. Instead, he goes for low-interest bearing government bonds that carry a lower risk of default. He particularly invests in long-term government bonds to take the advantage of capital appreciation as a result of fall in the interest rates. In the rising interest rate regime, he would shorten the duration of his portfolio to check on the losses as a result of falling bond prices. In short, he tries to ensure that the portfolio delivers reasonable returns by offsetting capital losses against capital gains in the long run. Dynamic bond funds are a good example wherein the fund managers use duration strategy.
Types of Debt Mutual Funds
Also read: Beginners guide to investing in mutual funds
Risks associated with Debt Mutual Funds
There is a very common myth that goes along with the debt mutual funds i.e. Debt funds are risk-free. However, that is not the case; debt funds also have inherent risk associated with them which affects its returns are listed below:
1. Interest Rate Risk
Interest rate risk is a function of bond duration. The longer the duration of a bond, the higher it is prone to interest rate risk. Also, the price of a bond is inversely proportional to the interest rate. So, if the interest rate rises in the economy, the bond price falls and vice-versa.
The increase in the interest rate may have a positive impact on the funds with a shorter maturity, on the other hand, if the interest rates are declining; it is a positive sign for funds having a longer maturity. So for instance, liquid funds have a negligible interest rate risk due to its shorter tenure when compared to gilt funds that have a longer tenure.
The Net Asset Value of debt funds also gets affected due to the change in the interest rates. In the case of fall in the interest rates, the NAV may increase in the short run and vice-versa.
2. Credit Risk
Credit risk implies creditworthiness of the entity issuing the bond and its ability to pay the interest timely and repays the principal upon maturity. If the issuing authority fails to make the payment, bonds are considered to be in default.
Credit rating agencies give a rating to the bonds. A bond with AAA rating is deemed to be the safest with negligible risk of default. The rating moves in the descending order from AAA to AA, A, BBB, BB, B, C and D. If the credit rating goes down, the bond price falls thereby having an adverse impact on the bond funds. You should keep in mind that you don’t expose your portfolio to a higher credit risk by purchasing low-credit-rated high-interest bearing bonds.
3. Liquidity Risk
Liquidity is one of the major concerns of the investors as they may want to exit the scheme without having to lose significantly. Debt mutual funds are very liquid as you can withdraw your money at any time. However, if you take out your money before the minimum period prescribed to stay invested, you may end up paying exit load that may vary from 0.25% to 2% depending on the fund.
Fund manager needs to keep high-credit-rated bonds in the portfolio to ensure its liquidity. Any investment in low-rated bonds may have an adverse impact on the liquidity creating difficulty for the investor to sell the bond in case of any emergency. Government bonds and money market bonds are considered more liquid due to the high participation from the investors.
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While debt funds are a safer bet as compared to the stocks, you should keep in mind that there is a level of risk inherent in every investment. Have an in-depth understanding of the structure and investment strategies of the debt funds. Consider the risk factors. Check whether the investment strategy of the mutual fund scheme conforms to your investment objective. Read the offer document carefully before investing.
Also read: How to select a good Mutual Fund that suits you best
Hi Kishor, nice article. What are the implications on returns of staying invested beyond the average maturity of a fund? Say I have a sum which I do not need for 2 years so I match this timeframe by investing in a short term fund. However after 2 years, I find I still do not have use for the money and decide to stay invested. Will it impact returns in any way on the upside or downside, if so how? If not, why does everyone say match your investment horizon with the average maturity of all securities in the fund?
You are absolutely right to say that the investor should match the investment horizon with the average maturity of securities. The logic behind this is to provide financial access to a particular financial goal as soon as it arises. A mismatch in the time of cash inflow and cash requirement may cause problem. Investing is all about making the funds available at the right time in the right manner. If you get money before it is required, then it may lie idle or may be diverted to non-priority goals. If you don’t get money when it is required the most then your goal may remain unaccomplished. So, remember to finance short-term goals with short-term investments and likewise.
Moreover, in case of debt fund, the return may be subject to vulnerability on account of fluctuations in the interest rate regime in case you stay invested beyond the average maturity of a fund.
Hi Kishor, thanks for your reply. Returns are subject to interest/credit/liquidity risks whether before or after maturity anyways. What is it specifically about remaining invested beyond the maturity that has an added component of risk? Or is there is no problem at all? If there’s no problem, why the whole point of matching horizon with the average timeframe?
Instead of short term debt funds (for which I was seeking an answer), lets take liquid funds as an example to illustrate the same principle. Retail investors use it to park funds for emergency for an indefinite amount of time. Yet, the average maturity is but a few weeks for such funds, thus the time invested is > maturity of the instruments. What is the incompatibility here?
Average maturity basically means the sum of individual maturities of all the securities put together that a debt fund holds. Suppose a debt fund holds 3 securities each having maturity of 3 years, 2 years & 5 years respectively. So, the average maturity of the debt fund would be around 3.3 years. The concept of average maturity has 2 linkages. Firstly, the average maturity of debt fund is not constant. It changes as the debt fund adds new security or churns the portfolio.
Secondly, average maturity changes the risk-return dynamics of a fund. The higher the average maturity, the higher NAV fluctuates. This would increase the risk of the fund and would consequently increase the Standard Deviation (SD) of the fund. The higher the SD of a fund, higher is the probability of losing the expected returns. This is analogous to the difference between GILT funds & Liquid funds. As liquid funds have shorter average maturity, these are less volatile than GILT funds. But, as you know returns are incidental to the risk assumed, GILT funds deliver higher returns than liquid funds. That is why; GILT funds are suitable for those who value high returns more than stability
Thus, if you hold your investments beyond the average maturity of a fund, you would lose on your returns.