What are debt mutual funds and what is the credit risk involved

Published: January 2, 2019 1:56:27 AM

Investors should, however, understand that these are MTM products and, thus, exposed to market risk. Further, investors should avoid concentration of the risks identified.

While the recent rating downgrades and ensuing liquidity crisis may have caused some nervousness, investors should not get swayed but look at the portfolio of the underlying funds to map their risk-return profile.

By Bhushan Kedar  

Debt mutual funds have emerged as a strong investment alternative to traditional fixed income instruments. The ability to generate mark-to-market (MTM) returns and indexation benefit for an investment horizon of over three years have catapulted these funds higher on the popularity chart than the traditional favourites—fixed deposits. Numbers corroborate this trend: debt mutual fund folios as a percentage of total individual investors folios increased to 14% in September 2018 from 7% in September 2009. While the recent rating downgrades and ensuing liquidity crisis may have caused some nervousness, investors should not get swayed but look at the portfolio of the underlying funds to map their risk-return profile.

What are debt funds?

Debt mutual funds are professionally managed, market-linked products that invest in money market instruments, bonds and government securities. There are several products within the category to cater to different risk-return profiles and investment horizon. However, since these are MTM products, they are subject to certain risks, which are detailed below.

Investments in debt mutual funds are subject to three primary risks—interest rate, credit and liquidity risks. Interest rate risk is sensitivity of a fund’s portfolio value to the changes in the interest rate. It is measured by modified duration. Typically, higher the fund’s duration, more it is exposed to the interest rate risk. In fact, rise in interest rate adversely impacts long duration debt instruments. Long maturity/ duration funds such as gilts are more exposed to this risk than short maturity funds such as liquid, ultra-short and short duration funds.

For instance, gilt funds gained nearly 15% on an annualised basis in the declining yield phase of 2014-16 and gained only 2.2% on an annualised when yields trended up recently. Moreover, selection of funds is important in the duration play as performance can vary widely based on the fund managers’ view on the interest rate trend. For instance, when yields sharply corrected in 2008, absolute returns of funds in the category varied widely from a low of 1.3% to a high of 38.6%. Hence, long maturity funds require more tactical calls for investors compared with short maturity funds.

Credit risk

Credit risk is the risk of default in payment of coupon and/or principal by an issuer. Lower the credit rating, higher the credit risk. For instance, a downgrade from AAA to AA for a security that accounts for 10% of the portfolio can shave 53 basis points (bps) off the returns, compared with 11 bps points for a 2% exposure. Investors can limit these risks by choosing well-diversified funds with higher exposure to high credit rating papers (AAA/ A1+).

Liquidity risk is the risk the fund is exposed to in liquidating the invested assets in case of dire circumstances. Analysis shows that the liquidity risk increases as the rating of the invested instruments goes down. Thus, investors can reduce this risk by investing in funds with a higher rating.
Based on Sebi’s current classification, there are more than eight debt fund categories to choose from based on one’s risk-return profile and investment horizon. Investors should, however, understand that these are MTM products and, thus, exposed to market risk. Further, investors should avoid concentration of the risks identified.

Lastly, investors can also monitor information available in the public domain such as financials, corporate news, issuer equity price movement and data on intra-month trades / intra-scheme trades of the issuers in the portfolio to keep abreast of any risks. In a nutshell, debt mutual funds are safe, but not risk-free.

The writer is director, Capital Markets-Funds Research, CRISIL

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