Investing in debt funds? Know your risks

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Published: June 12, 2019 12:32:10 AM

The most important factor to be considered about the issuer of debt, is the ability to repay the capital, and also the interest payouts.

As an investor, it is important that we know what exactly constitutes risk and what is uncertainty (Illustration: Rohnit Phore)As an investor, it is important that we know what exactly constitutes risk and what is uncertainty (Illustration: Rohnit Phore)

As various types of risks are repeatedly being noticed in the last 12 months across debt and equity asset classes, investors are a worried lot. Mutual fund investments have also been exposed to these risks, especially the debt funds, which has not helped the new investors to increase the investment corpus nor has it helped the old investors, who are seeing losses.

Risk can be of various types. For one, systematic risk is the kind of risk of losing investments due to factors such as political risk and macroeconomic risk that affects the performance of the overall market. Secondly, unsystematic risks which are existing but are unplanned and can occur at any point of time causing widespread disruption.

Know your risks
Knowing the above risks, when an investor invests, he encounters investment risk. This is basically, the probability or likelihood of occurrence of losses relative to the expected return on any particular investment.

Is risk an uncertainty? Definitely not. Let us know the difference. What constitutes risk is noted above and risk can be mitigated, if known. Uncertainty, on the other hand, is a situation, where the outcomes or potential probabilities for a loss are unknown and unknowable.

As an investor, it is important that we know what exactly constitutes risk and what is uncertainty, as it will drive your investment decision. The happenings in the debt funds have shaken the morale of the investor as the notion that debt is safer than equity has taken a beating . Well, in the first place, debt was never safer than equity. Debt investments are exposed to credit risk, default risk, interest rate risk, reinvestment risk, to name a few. And in the recent past, the investors have had a taste of all the above risks.

Checklist of risks
As an investor, how can you be protected or insulated as much as possible from these risks? Having a checklist is the key along with the tuning of one’s behavioural approach. And it is the behaviour, which drives our investment decisions.

As investors, majority of us look at the return part first, consigning the risk to the background. However, it is important to look at risk first and then the returns. Risk for investment in equity and debt, though similar, have specific nuances.

In equity, typically one can exit the stock (if not illiquid), and contain the losses, if any, thereby providing liquidity. However, in a debt investment, if the issuer decides not to pay the interest or defaults in repaying the capital, the recourse left to the investor is minimal. The most important factor to be considered about the issuer of debt, is the ability to repay the capital, and also the interest payouts.

And if you are an investor in debt mutual funds, you need to look at the portfolio of the investment holdings of the debt schemes. Are the investments those of the parent companies or that of its subsidiaries? If it is of the subsidiaries, then one needs to have a deeper look into the financials of the same.

Look at ratings
One should also look at the ratings and invest only in AAA / AA rated securities. However,ratings of ‘investment grade’ can overnight fall to ‘default’ grade which is not helping the investor to trust the ratings.

Fear and greed have been co-existing from ages and will continue to be so in the future. The recent incidents of risk fallouts should encourage us to invest more responsibly and seek out investments which cater to our needs. Shunning the investment asset class or equating all the asset classes in the same weighing scale is not the approach.

The writer is managing partner, BellWether Advisors LLP

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