Don’t ignore the Risk in Debt Mutual Funds

Risk in debt mutual funds

Share

Equity funds are risky but debt funds are safe. Isn’t that what most of us think?

That is clearly not the case.

Debt funds carry risk too, something that is ignored by many investors.

Many argue for debt mutual funds as a replacement for bank fixed deposits. In fact, I have written a post comparing debt mutual funds and fixed deposits and how debt mutual funds can provide better tax-efficient returns in specific cases.

However, it is never as simple. You need to select the right debt funds too.

A regular reader made an investment in a long-term debt fund on the basis on the post in early Feb, 2017. As on April 20, 2017, he was sitting on a capital loss of 2.5% in a debt mutual fund. He did that because I advocated debt funds (ahead of fixed deposits). Not only has he has lost out on interest income from fixed deposits, he is actually down on the capital.

I have myself booked losses in a long term debt mutual fund in the year 2013.

This is a far cry from the assured returns in bank fixed deposits. By the way, I have never advocated investment in long term debt funds (as a replacement for bank fixed deposits).

Yes, there are certain variants of debt funds whose risk-return profile may bear resemblance to bank fixed deposits. However, that does not mean that debt mutual funds are as safe as bank fixed deposits. Clearly, there is a higher risk in case of debt mutual funds. There have been quite a few defaults in corporate bonds over the last few years (IL&FS default being the most recent one). Even though the Debt MFs invest in bonds from multiple companies, such defaults affect your fund’s performance.

Well, banks can default too but how many times have we heard that in India?

Debt mutual funds provide market-linked returns. Therefore, returns from debt mutual funds can be much more volatile.

I guess I should set the record straight.

When we compare the products, the focus is only on the returns while we completely ignore the risk involved. In this post, I will discuss the risks associated with the investment in debt mutual funds.

Read: How to select a debt mutual fund for your portfolio?

How do debt mutual funds work?

Your investment is pooled along with other investors and invested in debt securities (bonds, debentures) as per the fund mandate. Debt funds also diversify and do not put the entire corpus in a single security.

Clearly, the NAV of the debt MF will depend on the price of the underlying securities.

Therefore, the factors that cause risk to bond prices will cause risk debt mutual funds too.

If you are investing in a debt mutual fund, there are four types of risks that you should be prepared for.

  1. Credit Risk
  2. Interest Rate Risk
  3. Liquidity risk
  4. Market Risk

And different types of debt mutual funds take different levels of these risks.

Read: Different Types of Debt Mutual Funds


#1 Credit Risk

You have Rs 1,000.

10 of your friends need money. You give them Rs 100 each. There is an understanding that they will give the money back. Let’s assume there is no interest to be paid.

What if one of your friends defaults and does not return any money?

You get back only Rs 900. You incur a loss of Rs 100.

The very same thing can happen with debt mutual funds too. If they lend to a corporate which does not return the money, the mutual fund NAV will take a hit.

This is called credit risk. It is the risk that the lent money may not come back.

Now, let’s bring interest into the picture.

Why do you charge interest?

  1. Think of interest as a reward for delaying your consumption. Rather than lending your friend the money, you could have purchased something for yourself.
  2. To counter the effect of inflation: You could have bought 3 apples for Rs 100 today but you lent the money to your friend. You got the money back only after 3 years. After 3 years, Rs 100 can buy you only say 2 apples. Purchasing power of rupee has gone down. Your friends need to make up for the loss of purchasing power.
  3. For taking on the credit risk: As discussed above, your friend may not return the money. You need some reward for the risk you are taking.

A debt mutual fund can generate higher returns by taking on credit risk

You have two friends named Responsible and Irresponsible.

Responsible has a good financial position and has a good track record of returning the borrowed money.

Irresponsible is not in a very good financial position and a patchy record when it comes to timely repayments.

Will you offer them money at the same interest rate?

Clearly, no. You will want a premium from Irresponsible because you are taking greater risk.

Now, extend this example to debt mutual funds. A debt mutual fund (Fund A) can generate higher returns by lending to companies that are not in a good financial position.

If everything is well, such a fund will generate better returns than Fund  B that invested only in high credit quality securities (good financial position).

If you focus only on the returns, Fund A will look more appealing than Fund B.

However, don’t ignore the risk.  The additional returns have come by taking extra risk. Just that the risk has not manifested till now.

You must go through two brilliant pieces on a recent default by a corporate by Deepak Shenoy, Founder, CapitalMind. The links to the articles are in Additional Read section.

How do you figure out Credit Risk?

For you, it is not possible to research every security in the debt fund before investing. You rely on credit ratings given by credit rating agencies such as Crisil, Care etc.

Do note you cannot take these ratings on face value. There have been umpteen examples where the rating agencies have been caught on the wrong foot. Sub-prime crisis in 2008 is a prominent example. Closer home too, credit rating agencies have erred. IL&FS had the highest credit rating in August 2018 and it defaulted on its payment a few weeks later.

Moreover, the fact that the borrower pays for the ratings may compromise the judgement of the credit rating agencies.  The rating agency will think twice before giving a poor rating to the company. The payments will likely stop soon after.

Crisil transition table debt mutual funds are risky too 2 risk in debt mutual funds credit risk interest rate risk

The borrower with credit rating AAA is less likely to default as compared to that with rating say A. CDR stands for comparative default rate.

None of the companies that were rated AAA by CRISIL have defaulted in the next 3 years. Only in 0.04% cases where the issue was rated AA defaulted (rating moved to D) in the next 1 year.

risk in debt mutual funds credit risk interest rate risk

The ratings are not permanent. The ratings can change depending upon borrower’s business and financial performance.  So, even if the rating was AAA at the time of investment, it can go down later.

For NAV of your fund to be affected, the borrower does not have to do a full-fledged default (not paying interest or principal). NAV of your fund can also be affected due to credit upgrade or downgrades.

Clearly, a credit upgrade will affect the NAV positively while credit downgrade will affect the NAV of the fund adversely.

This happens because credit spread (premium over the Govt. securities) rises in case of credit downgrade. The reason is the same. You want a higher return for taking greater risk. For you to get a higher return, the price of the bond has to go down (discussed in the next section).

By the way, the credit spreads may rise or fall without any credit event too. The spreads may rise or fall due to the change in perception of risk for various ratings of bonds.


#2 Interest Rate Risk

Bonds prices and interest rates are inversely related.

When the interest rates go up, bond prices go down.

When the interest rates go down, bond prices go up.

Why? Let’s find out.

You have Rs 10,000 to invest.

You invest in a bond (debt security) from company X that will give you 8%  p.a. return. Let’s say the security matures in 1 year.

After 1 year, you will get Rs 10,800 back (Principal of Rs 10,000 and interest of Rs 800).

Let’s say the interest rate suddenly move up to 9% p.a i.e. the same borrower (Company X) is willing to give 9% p.a. on 1-year bond.

Now, let’s assume an investor M wants to invest in bonds from company X.

You are willing to sell it at Rs 1,000.

But M will not buy it from you because he will earn only 8% while he can easily earn 9% by purchasing new bonds.

Not just M, nobody will buy it from you unless you match the yield (return) of 9% p.a..

And how do you do that?

You can’t increase the interest rate (coupon) because that is fixed at 8% for your bond.

To match the return of 9%, you will have to lower the selling price. You will have to sell at Rs 9,909.

If M buys your bond at Rs 9,909 and gets a total of 10,800 after 1 year (coupon of Rs 800 and principal payment of Rs 10,000), his return is 9% p.a.

The interest rate went up, and the bond price went down.

I leave it to you to figure out how bond price will go up if the interest rates were to go down.

In the above example, the interest rate went up by 1%, the bond price went down by 0.9%.

It will not work the same way with all the bonds.

The extent of change in the bond prices due to movement in interest rates will vary across bonds. Modified Duration is such measure of interest rate sensitivity of bonds. You can read about the exact calculations on the internet.

A bond that matures in 1 year will have lower modified duration than the bond that matures in 10 years.

Longer the maturity of bonds, the higher the modified duration.

If the modified duration of the bond is 10 years, the price of the bond will rise (or fall) by 10% for every 1% cut (or hike) in the interest rates. Scary, isn’t it?

Since a debt mutual fund invests in multiple bonds, the modified duration for the mutual fund is the weighted average of the duration of underlying bonds.

Liquid funds invest in very short term securities and hence have low modified duration. Therefore, liquid funds are the least susceptible to interest rate movements.

On the other hand, long term debt funds have the highest duration (since such funds invest in higher maturity bonds) and are the most volatile. Long term debt funds will rise the most (if the rate is cut) and fall the most (if the rate is hiked). With long term debt funds, the fund manager takes active interest rate calls.

Do note capital markets work on expectations. Bond prices may move much prior to actual event (in anticipation of a rate cut or hike). For instance, bond prices may go up in expectation of an interest rate cut. If the anticipated trend does not happen, the price trend may reverse.

Something similar happened in February 2017 when rates were not cut by RBI as anticipated and surge in bond prices (debt fund NAV) reversed.


Where do you get information about Credit Quality and modified duration?

The best place is the Scheme Information Document. Go through the investment objective. Have look at where a particular scheme can invest. You can also look at monthly factsheets to see how the portfolio has evolved.

For shortlisting, you can go to ValueResearchOnline or MorningStar.  I have pasted the information below for a liquid fund, two ultra short term debt funds, and a long term debt fund.

Just by looking at this information, you will get a good idea about the duration of the fund and the credit quality of the securities the fund invests in.

This is just a starting point. You can’t just rely on ratings and information ValueResearchOnline or Morning Star for selecting a debt fund.

Moreover, this is a snapshot as on date. Fund manager may make different choices in the future.

Therefore, you must go through the Scheme Information Document too, which contains the information about where the fund manager can invest and the discretion fund manager enjoys.

Liquid Fund

risk in debt mutual funds credit risk interest rate risk

Ultra Short Term Debt Fund (with relatively low credit risk)

risk investment in debt mutual funds credit risk interest rate risk

Ultra Short Term Debt Fund (with medium credit risk)

investment risk in debt mutual funds credit risk interest rate risk

Long Term Gilt Fund

credit risk interest rate risk in debt mutual funds

Notice how duration has increased from liquid to ultra short term to long term debt funds. Long term debt funds are quite susceptible to rate movements.

Moreover, pay attention to where the fund falls in the style box.


#3 Liquidity Risk

Liquidity risk refers to the risk that you cannot access your money when you want to.

You purchased a share. Trading volumes for the scrip are low. One fine day, you want to sell a share but can’t sell it because there are no buyers or nobody wants to purchase at your price (bid-ask spread is high).

Bond markets are not as deep in India. This can happen with mutual funds too i.e. when fund wants to sell a security, it cannot sell it at the price it wants to or can’t sell it at all. A major fund house faced a similar issue while offloading bonds of a housing finance company in September 2018 (and took the stock market down with it).

Unless it needs the money, it can afford to wait.

However, when there is huge redemption pressure (say in case of the credit downgrade of a bond), the fund house may limit redemption. This is because the fund house needs to liquidate holdings to pay you and not all its holding may be liquid.  And that’s how liquidity risk comes into the picture.


#4 Market Risk

This is Economics 101. If there is too much selling pressure, the price goes down.  If supply is high and the demand is low, the price will adjust downwards.

So, if many investors start selling for any reason (say due to weakness in currency), bond prices may go down (despite little change in credit risk or interest rates). Fund NAV will also suffer. Quite possible selling pressure may abate in the near future and the bond prices will recover.

However, if you have to sell at the same time of selling pressure, your loss will become permanent.

Point to Note

Many of us compare the present rates offered in the Fixed deposit with the past returns (1-year, 3-year , 5-year etc) of debt funds. This is a wrong comparison.

What you are essentially comparing is the next 1 year return in fixed deposit with the past 1-year return in debt mutual funds? This is unfair to fixed deposits.

If the interest rate is on the downward trajectory, debt funds will look far superior, at least as far as returns are concerned. Long term debt funds will look even better (due to capital gains because of rate cuts).

You must compare forward returns in FD with forward returns in debt funds (which is not possible to know upfront). You must understand even debt funds invest in bonds. If the interest rates are going down, fresh bonds issuances will be at lower rates, which will show in lower returns in debt funds too (I am ignoring capital gains).

When the interest rates are going down, long term debt funds will do very well. You may earn magnificent capital gains. However, if you extend your stay and the interest rate cycle reverses, such capital gains may easily be wiped out.

What do I do?

I do not invest in bank fixed deposits.

Depending upon my requirement, I invest in liquid funds or ultra short term debt funds that invest in high credit quality securities.

This does not eliminate risk (read about Taurus Liquid Fund in CapitalMind article). However, I am aware of the risk and I have decided to live with the risk.

I do not invest in long term debt funds (or even dynamic bond funds) either because I do not want to take a call on interest rates movements.  Tax implications may also prevent from taking such active calls.

Just because I do not invest in bank fixed deposits (or long term debt funds) does not mean these are bad investments. Just that these do not meet my expectations.

My expectations from debt funds are quite simple. To generate stable, low volatility and tax-efficient returns.  Liquid funds and ultra short term debt funds should do the job well.

I use debt funds to lend stability to the portfolio. I take risk with my equity portfolio.

That’s my choice. And you don’t have to agree with me. After all, personal finance is personal.

I have seen investors loading their portfolios with credit funds (in search of higher returns). It is fine so long as you are aware of the risks involved.

Your expectations may be very different. And hence the choice of your debt investment may be quite different.

Whatever you do, don’t ignore the risk.

If you find this a bit too much to handle, you can consider seeking professional advice from a SEBI Registered Investment Adviser (or a fee-only financial planner).

If you liked the post, your friends may like too. Please share with our friends

Additional Read/Source

Different Types of Debt Mutual Funds (SEBI Categories)

5 Financial Habits that can ruin your Financial Life

CapitalMind: How Mutual Funds handled Ballarpur debt default?

CapitalMind: Why Taurus MF has let sell your units but not buy more?

LiveMint: Debt Funds are risk-free. Tread Carefully.

Should you invest in Corporate Fixed Deposits?

33 thoughts on “Don’t ignore the Risk in Debt Mutual Funds”

  1. Hi Deepesh,
    Good and informative blog, which clear the debt fund fundamentals. Meanwhile what is your views on Dynamic asset allocation funds or balanced funds which invest in both debt and equity? As market is at high levels.

    1. Deepesh Raghaw

      Thanks Santosh!!!
      Will really appreciate if you could share with your friends too.
      There is risk with Dynamic Asset Allocation Funds and Balanced Funds too.
      The extent of the fall (if the markets) will depend on percentage of equity in the portfolio and how the equity portion of portfolio performs.
      With balanced funds, fund manager needs to have at least 65% equity exposure (many fund managers have more).
      With dynamic asset allocation, net equity exposure can be much lesser (depends on the underlying model).
      With dynamic asset allocation,it depends on the underlying model, if there is any. The allocation to equity and debt is decided based on a pre-set criteria.

      1. Sure. Deepesh I will share it.
        Thanks for the quick reply. Will you advice to shift the SIPs to DAA funds and balanced funds when valuations are so high?
        What will be the tax treatment on them. Will they be qualified for zero Long term capital gain tax if they have more than 65% equity portion at the time of resumption or is it mandatory for them to maintain min 65% equity. For eg. ICICI Pru Balanced Advantage fund have only 52% equity portion right now. Will such fund such funds get zero LTCG tax

        1. You are welcome, Santosh.
          I will not venture into investment advice. If you feel the markets are overvalued, you can consider increasing allocation to debt in your portfolio.
          I prefer balanced funds over Dynamic asset allocation funds for long term goals. Even balanced fund adjust allocation every month.
          For DAA funds, a lot depends on the underlying model.
          Balanced funds get tax treatment of equity funds.
          For DAA, it is a bit complex. Some of funds are funds and funds (FoF), which get tax treatment of debt funds.
          DAA funds can adjust NET equity exposure by shorting index futures in the market. Therefore, from taxation standpoint, the overall equity holding is greater than 65% but the net holding is way less. Such funds will enjoy equity tax treatment.
          Go through Scheme Information document of the schemes to figure out.

  2. Thank you sir. It is all very informative and an eye opener to those who assume debt funds to be a safe investment destination. I have shared this information in Vajiram Civil services aspirants group.

    1. Deepesh Raghaw

      Can’t comment. Whether the decision is right or not depends on why you invested.
      If you invested in an equity fund and do not need the money for 15-20 years, then it should be good choice.

  3. Good Post at Right Time.!
    For the recent days both liquid and debt funds – ust, are making similar returns only. Any views?

    Reg, referral, I would suggest to do following feasible model:
    – Declare a nominal fee as ArthaYantra, Robobanking does. This will get you more members
    – To create whats app group for regular updates to your members
    – I understand everyone has their own goal and so the portfolio plan varies. But consider an overall common goal for everyone which are Kids Education/Marriage expenses, retirement corpus etc. You can derive a portfolio for these common goals for a given age range of people.

    Just my one cent !!

  4. Pradip Gupte

    Thanks for this information which factored in my experience of investment in GILT long term on 7Feb17

  5. What else ( deciding ) parameters to be considered other than these FOUR, say yield to maturity, no of scripts,. riskometer, risk grade, Fund Manager etc

    1. Deepesh Raghaw

      I don’t worry much about fund manager in case of debt funds. YTM does not tell me much either. For short term funds, portfolio will churn automatically in 6-12 months.
      Size of the funds is important too. I prefer larger funds. Prefer bigger fund houses.
      Text in SID tells the kind of leeway fund manager enjoys.

  6. Mutual funds are subject to stock market conditions. Moreover, it is a general notion that only equity mutual funds are risky, whereas, debt mutual funds are risk-free, which is certainly not the scenario. This blog explains the risks involved in debt mutual funds and helps to understand that in which debt mutual fund money should be invested.

  7. ARVIND AGARWAL

    Could you please clarify how Gilt Mutual funds are able to post return of over 13- 15% while government securities seldom carry coupon of over 7%?

    1. Deepesh Raghaw

      Hi Arvind,
      That is because interest rates have dropped sharply over the lat few years.
      Bond prices (debt mutual funds invet in bonds) and inversely proportional.
      As interest rates go down, bond prices go up.
      The extent of move depends on the maturity profile (duration) of the debt mutual funds.
      Higher the duration, greater the interest rate sensitivity.
      For long term funds, duration is quite high and that’s why such funds have given good returns.

  8. Investing in debt mutual funds entails taking on some inherent risk, which an investor should be aware of. And the time to spread this awareness couldn’t be more apt with the domestic fixed income market witnessing an extremely turbulent phase.

  9. OnCredit Risk:
    If company is ‘Default’ on interest/principal payment, does the company need not pay back to AMC, by seling their properties etc ?
    If GOI Sec are safe, why dont we discuss about Short Term Gilt Funds – Credit Safe and Low Sensivity too….

    1. Deepesh Raghaw

      Hi Sunil,
      Depending upon if the investment was secured or unsecured.
      However, liquidating asset is not so straight-forward. There are numerous legal and operational hurdles.
      Please try to relate to the NPA problem faced by banks.
      Yes, short-term gilt can be a good option for long term debt portfolio. No credit risk but some level of interest rate risk.
      However, with SEBI categorization coming into play, these funds are not likely to continue in their present avatar.
      In my opinion, that is unfortunate.

      1. Reg SEBI categorisation, you picked up right.. unfortunately short term gilt fund has min 10 yrs duration which is actually not a short term so high sensitivity.

        If liquidity is not a concern , additional contributions to EPF is the best w.r.to debt portion of one’s investment.

    1. Deepesh Raghaw

      Hi Sunil,
      AMCs have a little discretion in how they choose to account for the default.
      Some may write it off completely (typically followed by restricting further purchases in the fund).

  10. In that case , VPF will be the best option , when liquidity is not a concern. I would suggest that you can write a separate post on the same

  11. Hello Deepesh,
    Thanks for this post.
    What are your views on
    “Franklin India ultra short bond fund-super institutional plan ”

    Thanks.

  12. Hello Deepesh,
    Thanks for your informative blog.
    I want to invest 3 lakh for my SIPs upto next 1 .5 years through SWP route.

    For lumpsum amount ,which Debt fund is preferable ,why ?
    A)
    Ultra short term debt fund from well established AMC
    Giving 8% return last year
    But investing in 40 % in AAA papers, 40 % in AA papers ,and 20 % in A & below papers.
    B)
    Ultra short term debt fund from well established AMC
    Giving 7 % return last year
    Investing in 70 % in AAA papers, and 30 % in AA papers.
    C)
    Liquid fund which
    Gives 6 % return last year

    Thanks.

Leave a Comment

Your email address will not be published.

This site uses Akismet to reduce spam. Learn how your comment data is processed.