Debt funds are not as safe as you thought, invest carefully
As bank deposit rates fall, there is increasing retail interest in debt funds and many investors believe that equity is risky but debt is safe. You’d be right in making this judgment call if the ‘debt’ was a bank fixed deposit or a government-guaranteed bond. But debt mutual funds carry risk. The risk in debt funds comes from several sources. The first is interest rate changes, or an interest rate risk. This is the risk of your fund manager’s interest rate call going wrong. We know that bond prices rise when interest rates fall. If your fund manager expected rates to fall and managed his portfolio (I am deliberately not using jargon here, but for those interested do look up ‘duration’) accordingly, but rates went up, your investment will compare unfavourably with others who took the right interest rate call.
The second is the risk of default by the borrower—or a credit risk. Funds are allowed to invest in debt papers that are rated investment grade by credit rating agencies. But within this band of investment grade, it is possible for fund houses to invest in lowerrated papers than the safest paper in the market. When things go wrong for the firm that borrowed money from the mutual fund, the credit ratings can drop sharply and the value of the fund suffers. When such an event happens (we’ve had three such cases in the past few years) and there is a big redemption pressure, the third risk kicks in: lack of liquidity—or the lack of a market when you want to exit. The non-government Indian bond market is not very liquid, that is, fund managers may not find buyers if they need to sell in distress.
Unlike equity, debt fund risks are much more difficult for the retail investors to understand. Not just investors, even mutual fund agents and advisers may not correctly understand all the risks or have the ability to analyse portfolios. Some of them have pushed the concept that debt funds are safe and equity is risky. Debt fund investors have chased higher returns believing that debt funds are ‘safe’. As funds have flowed into schemes that performed better than others in their category, mutual funds have increasingly begun to take credit risk, that is, buy paper that is investment grade but lower rated by credit rating agencies. Remember that less creditworthy firms need to offer higher interest to borrow in the market. When the mutual fund buys lower rated paper, it increases the risk on your investment. Fund houses have come up with innovative names to indicate the higher risk such as ‘credit opportunities funds’. But the retail investor understands ‘opportunity’ not as risk but as a good opportunity to earn better returns, forgetting that higher returns come with higher risk.
What can you do? Unless you can analyse portfolios of funds, understand credit ratings and can evaluate concentration risks, do not attempt buying debt funds on your own. The market regulator needs to find ways of labelling debt funds that make it easy for the retail investor to buy these excellent products that are misunderstood today. Find a good planner and then on-board debt funds.