Debt mutual funds are those funds that invest their assets in corporate bonds, government securities, and various other money market instruments. Most of the investors are not aware of the fact that even debt funds are also risky. There is a difference between volatility and risk. Volatility can be viewed as how frequent a change occurs in the value of the securities while on the other hand risk must be viewed as the probability of losing the invested capital amount. Without any doubt, we can say that equity markets are more volatile than debt instruments. But do both the asset classes carry the same amount of risk? Well, in our view it is not. It might shock you that debt funds are even riskier than equity funds at times. The reason being that if underlying paper defaults on payment then the entire invested amount is exposed to risk while in case of equity mutual funds the fund house can exit the particular company at a loss and would be able to recover at least some amount.
There are various kinds of risks which are faced by the debt funds. These risks have been discussed below: –
1.) Credit/Default Risk
Credit risk can be viewed as the possibility that the issuer of the bond may default on the periodic interest and also on the principal amount at the time of maturity. There are funds like credit opportunities fund and corporate bond funds which invest in low rated papers as they tend to give higher returns than the instruments with high ratings. These low rated papers usually carry a higher risk of default and if the call of the fund manager goes wrong then the NAV of the fund will take a hit.
DHFL and IL&FS are the recent examples of debt instruments that have beaten down the NAVs of the funds that were holding these two bonds in their portfolio. Generally, in case of default, mutual fund scheme has to write off the investment made from the NAV and create a side pocket.
“Side Pocketing” – “Side Pocketing” – Side Pocketing is a mechanism to separate distressed assets from other more liquid assets in a portfolio at the time any credit event like sudden downgrade by CRA (Credit Rating Agency). The rationale behind creating a side pocket is to prevent the bad assets from damaging the overall returns of the portfolio. For example, if a bond in the portfolio turns bad then a large number of investors will come up to redeem their investments to prevent it from falling further and to meet this liability AMCs will have to sell other liquid bonds, thereby will incur some losses.
The side pocket is formed by creating a separate portfolio of distressed assets. So as a result, there will be two sets of NAVs of the fund wherein one NAV denotes the value of the liquid portfolio of fund while the other denotes the value of segregated/ illiquid bond portfolio. Investors will get an email or SMS on the day of the creation of side pocket.
Each investor is allocated his / her proportion in the side pocketed portfolio on a pro-rata basis. When recovery is made in the side pocketed portfolio, the same is distributed amongst those investors on a pro-rata basis. No investment and advisory fees can be charged by the AMC on the side pocketed portfolio. However, TER (excluding the investment and advisory fees) can be charged on the side pocketed portfolio but only upon recovery, on a pro-rata basis i.e. on the recovered amount.
Side pocket is usually created when a bond falls below investment grade (i.e. when the long term rating falls below BBB – or short term rating of below A3). Creating a side pocket is not mandatory and is at the discretion of the AMCs and trustees.
2.) Interest Rate Risk
A change in the interest rate scenario in the economy also affects the returns from a debt fund. Interest rates usually affect the debt funds holding long-duration bonds. Long duration funds perform exceptionally well in case of a falling interest rate regime. For example, in a falling interest rate scenario the new bonds will come up with a lower yield and hence the bonds with higher yields will become more attractive. As a result, the value of these bonds will go up in value and the NAV of the schemes holding higher yield bonds will see a jump. While on the other hand, in a rising interest rate scenario these funds will be adversely impacted.
Mutual fund schemes like liquid funds or ultra short term funds are not impacted by the changing interest rates in the economy as the underlying securities held by these schemes are of shorter duration.
3.) Concentration Risk
Diversification is the best way of minimizing the risk of the portfolio. Hence, an investor should check that whether the portfolio of the scheme is well-diversified or is concentrated towards only a few instruments. A scheme should ideally not hold more than 3-4% of its total assets in a single debt instrument as this would not hit the overall returns badly.
4.) Reinvestment Risk
One of the risks that are faced by debt mutual funds is reinvestment risk. The periodic coupons received on the bonds and also the maturity amount have to be reinvested at the prevailing interest rates. But the interest rates at the time of reinvestment may or not be the same; it could be higher or lower or even at the same level as the interest on original bonds. When the coupons and the maturity amount are reinvested at a rate lower than the interest rate on original bond, it is considered as reinvestment risk.
YTM (Yield to maturity) of the bond portfolio is calculated based on the assumption that the coupon and the maturity amount will be reinvested at the same interest rate as that of the original bond. But when the coupons and maturity amount are reinvested at a different rate, the investors’ returns may vary.
5.) Liquidity Risk
Returns from the debt funds can also take a hit due to the liquidity risk specific to a particular bond or due to the bond portfolio as a whole. Sometimes panic among the investors caused due to a single debt instrument can put redemption pressure in a particular mutual fund scheme which may compel mutual fund managers to sell other bonds in the portfolio at a lower value to meet redemption liabilities.
Also, when a supply of a particular bond increases due to any downgrade or any other reason the value of the bond falls which inversely hit the NAV of that particular scheme badly.
No investment avenue is risk free. Hence, an investor should consider all the aspects pertaining to an instrument before investing whether it is debt mutual fund scheme or equity mutual fund scheme. Also always ensure that the investment is suitable for you and link it with your goals for desired results.