Every coin has two sides and so does investing in debt. There is no such thing as a completely safe or risk-free investment. So, while the debt market is wooing investors with its safe-keeping ability, understanding the risks involved within this market is a good idea if one is to stay a step ahead of danger this time around. The markets may be choppy but everyone is of the opinion that even in, and especially in such times, there are big opportunities and risks both available. Many of the investment gurus in India, including Rakesh Jhunjuhunwala has said, “This is a great time to start investing in the equity market. There are many good, sound and fundamentally strong companies in India that are doing well and are available at fabulous prices right now.” The unfortunate truth remains that majority of the investors are still weary of the equity market and have shied away from them for now.

If one recollects India’s recent inflation hike, in the midst of the financial downturn and market slump, it comes as no surprise that investors had a very quick change in their mindset, with “play it safe” and “wait and watch” being the new mantras of the day. This led to other investment options, namely debt investments as one of the preferred investment options, people took to.

Debt investing risk primer

K Ramakumar, head fixed income, BNP Sundaram, feels “Any and every investment involves risks. There are no free lunches anywhere. As far as investment risks go, they vary from investment to investment. Just like lending the government money and lending a paan shop money has two different risks; similarly within the debt market different bonds have different risks. Be it oil bonds, central government bonds, state bonds etc.

The risk is different everywhere as there are different funds present in the market place. Each fund captures a different risk, be it interest rate risk, market risk or credit risk. For example, in a government securities fund, an investment happens on a government paper. The government is a really safe place to invest since the government is unlikely to default. However, here too the interest rate risk is present. These securities are sold as credit risk-free since the government will honour them and pay up the interest as well. Yet, they too have a certain risk element involved.

Income funds and long-term debt funds on the other hand which invest in both government securities and corporate bonds, manage to capture both the credit and interest risks, which are the two major risks in the debt market.”

Type of risks

One should always assess the kind of securities the fund they are investing in will have and the type of risk associated with it.

•Interest rate risk

Interest rate movements have an inverse relationship with the net asset value (NAV) of a fund. If rates rise, the NAV of a fund comes down and vice-versa. This is why people prefer investing in such bonds when they feel that the interest rates are going to be cut. This often affects longer-tenure funds such as medium and long term bond funds or gilt funds; these will get affected as they invest primarily in government bonds. Coming to how interest rate risks affect bond prices. If you own a bond paying 6% interest and want to sell it one year later on the open market when the interest rate is 8%, you’re going to get a lower price than what you paid. After all, why would anyone buy your 6% bond if he could get a new 8% bond? The only way he will do it is by buying your bond at a discount. The longer you hold your bond, the less likely you are to lose money on it. As bonds are typically a long-term investment, so this shouldn’t really be a big concern

•Credit risk

If your fund buys corporate bonds, it is essentially purchasing a claim to the assets of the company. Just as with individuals, corporations take on debt in the hope to grow. Sometimes, they take on too much or their operations start to perform poorly and they are unable to repay their debts. This is just like someone taking on too much credit card debt and then having to file for bankruptcy. At times, companies will file for bankruptcy and won’t be able to repay the principal on their debt. This means that the investor can theoretically lose his entire investment, although this is not a particularly common occurrence. In such a case, when the organisation that issued the bonds goes out of business for some reason, it will obviously not be able to fulfill any more interest payments or otherwise redeem the bond’s value, creating a credit risk

This risk increases/decreases depending on the reliability and stability of the company. Non-government or corporate bonds carry more of this type of risk than bonds issued by the government or government-backed organisations which are usually considered credit risk free as one does not expect the government to go bankrupt and shut shop.

•Liquidity risk

A while ago debt funds faced severe redemption pressures as companies reeling under the liquidity crunch pulled out money from liquid and debt funds they had invested in. This was due to a combination of reasons, like banks tightening working capital loans for companies and retail investors wanting to cash out as well. This led to massive distress selling by mutual funds coping with redemption pressures. With companies trying to get cash from the supposedly liquid debt assets and retail investors seeing yet another NAV drop in their portfolio, wiping away whatever returns they were making, the as such smooth working debt markets, crashed under selling overload.. While funds as such do not like holding too many illiquid papers, mutual funds, especially those with lock-in periods, do hold securitised papers, pass through certificates (PTC), securities issued by finance companies and also a few corporate bonds.

•Default risk

During times of financial troubles and slowdowns, there is a likelihood of companies which have issued debt, defaulting on their interest and principal payments. Credit defaults badly affect the NAV of the fund and can be a major threat to investors and the profits they have made prior to this lean patch. Such risks plague the debt market too, especially smaller companies who have issued debt and are now facing a cash flow problem.

•Regulatory risk

When the regulations that govern a particular market, in this instance the debt market, undergo changes, be it due to regulators being changed, new safety or modern norms being approached, then the debt market can take unforeseen turns, and this too is a risk that on should be aware of.

•Market risk

When a fund holds a lot of securities or bonds of a particular kind, say a 100,000 securities for example, and the market trade volumes for that security is 10,000 or so, one runs a market risk. This is to say that if the fund needs to liquidate these securities, then due to the thin trading volume, will cause the bond prices to drop drastically once these 100.000 shares are being offloaded.

This is a market risk which can occur when one fund holds a security that is not traded so heavily as the amount it wants to offload, or when the market situation is such that the overall trade volumes drop drastically.

•Settlement risk

This is basically a counterparty risk that exists when one buys securities and bonds from a third party. This risk lasts till the bond purchased reaches the fund purchasing it. This risk, however, is now not such a threat as you have a settlement guarantee fund and in most cases in India the counter party is the trading platform itself. ?

Current situation

While not too long ago, liquid and liquid plus funds faced a major crisis due to the sudden redemption pressure, things have improved now. The debt market is smooth and offers investors a safe place to keep money, provided no more panic situations arise. After the Reserve Bank of India (RBI) cut cash reserve ratios and opened a separate window for mutual funds to borrow against certificates of deposit, the debt market overload eased up considerably. Vikas Agnihothri, CEO, Religare Macquaire Wealth Management, said, “Investors have burnt their fingers before in the equity market and are now focusing solely on wealth preservation. The debt market is looking the most attractive currently and investors are still keen on keeping a sizeable portion of their portfolio invested in debt.” In India, unlike abroad, one cannot invest in debt instruments as a retail investor and that means the mutual fund route is what investors must use. This has in such times been a blessing in disguise for investors as the risks they could face have been considerably reduced. Last October, the liquidity risk which affected the market was an anomaly. As such, amongst all the risks mentioned the two most prominent ones that one should take care against are interest rate risks and credit risks. However, understanding the finer points of this debt market, which is playing safe haven to so many, is a smart move and hopefully one will not be caught in any of the obvious traps that this market brings with it.