Many people believe that debt mutual funds are not risky and can safely invest in them. The belief is not entirely true as it is rightly said that mutual funds are subject to market risk. While debt funds are relatively less risky than equity funds, they are not entirely risk-free. This blog will discuss the types of risks associated with debt mutual funds justifying the statement that mutual funds are subject to market risk.
Types of risks associated with debt mutual funds
As per the statement, “mutual funds are subject to market risk”, some of the risks associated with debt mutual funds include:
- Interest rate risk
Interest rate risk refers to the sensitivity of bond prices to changes in interest rates. Bond prices and interest rates have an inverse relationship. In a falling interest rate scenario, the bond prices move up, leading to an increase in the debt scheme’s net asset value (NAV). Similarly, in a rising interest rate scenario, the bond prices fall, leading to a fall in the debt scheme’s net asset value (NAV).
Currently (March 2022), inflation is running higher than the central bank target rate in many countries. The US Federal Reserve hiked interest rates by 25 basis points for the first time since 2008. The Fed has guided for six more rate hikes in 2022. The Reserve Bank of India (RBI) is also expected to start monetary tightening and increase the interest rate in the future.
The medium to long-duration debt funds are expected to get affected adversely during a rising interest rate scenario. On the other hand, short-duration debt funds are not expected to get affected that much. In a rising interest rate scenario, an investor should consider investing in low-duration funds rather than medium to long-duration funds.
- Credit risk
Credit risk refers to the failure or inability of the borrower to pay the interest or capital or both. It is also referred to as default risk. The creditworthiness of a bond is evaluated based on the credit rating given by the credit rating agency. The higher the credit rating, the higher the creditworthiness of the bond. The higher the rating, the lower the interest rate that the bond issuing organization will have to pay.
Whenever the credit rating of an existing bond is changed, it affects its price. When the credit rating is upgraded, the bond price will go up, leading to an increase in the net asset value (NAV) of the scheme holding the bond. When the credit rating is downgraded, the bond price will fall, leading to a fall in the debt scheme’s net asset value (NAV).
Credit rating agencies downgrade the bond credit rating when the repayment ability of the bond issuer is affected negatively due to any adverse event/s. A substantial fall in the bond credit rating can lead to investors panicking and rushing to redeem their mutual fund units. During such events, to meet redemption pressures, the fund manager may have to do distress sale of the bonds leading to a further fall in bond prices and thereby scheme NAV.
How to manage risks in debt mutual funds
In the above section, we have seen how debt mutual fund investment are subject to market risk. Now, let us understand how we can manage these risks.
- Managing interest rate risk
Although mutual funds are subject to market risk, you can manage the interest rate risk by choosing debt funds based on your investment time horizon. If your investment time horizon is up to 3 years, you can invest in debt funds with a lower Macaulay duration of up to three years. These debt funds include liquid funds, overnight funds, low duration funds, ultra-short duration funds, money market funds, short-duration funds, etc. The sensitivity of all these funds to interest rate changes is lower than funds with medium to long duration.
Similarly, if you have a medium investment time horizon (3 to 7 years), you can invest in medium duration funds or medium to long-duration funds. You can invest in long-duration funds or gilt funds if you have a long investment time horizon (above seven years).
Also, during a rising interest rate scenario, you should shift your debt investments to debt funds with low Macaulay Duration. You should shift your debt investments to debt funds with a long Macaulay duration during a falling interest rate scenario.
- Managing credit risk
You can manage credit risk by choosing debt funds based on your credit profile. You can invest in a corporate bond fund or gilt fund if you have a conservative risk profile. A corporate bond fund invests a minimum of 80% of its assets in the highest-rated debt instruments. Similarly, a gilt fund invests a minimum of 80% of its total assets in Government Bonds. If you have an aggressive risk profile, you can invest in credit risk funds. These funds invest a minimum of 65% of their total assets below the highest rated debt instruments.
Mutual funds are subject to market risk
We have understood how debt funds carry relatively lower risks than equity funds but are not completely risk-free since mutual funds are subject to market risk. You can handle the interest rate risk by choosing debt funds based on the Macaulay Duration, investment time horizon, and the interest rate scenario (rising/fall). The credit risk can be handled based on risk profile and choosing between corporate bond funds and credit risk funds.