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 replacement for 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 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 replacement for bank fixed deposits).
Yes, there are a 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 higher risk in case of debt mutual funds.
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 investment in debt mutual funds.
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, 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.
- Credit Risk
- Interest Rate Risk
- Liquidity risk
- Market Risk
#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 picture.
Why do you charge interest?
- Think of interest as a reward for delaying your consumption. Rather than lending your friend the money, you could have purchased something for yourself.
- 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.
- 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.
Book Suggestion: Bogle on Mutual Funds: New perspectives from the Intelligent Investor (John C Bogle)
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.
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 poor rating to the company. The payments will likely stop soon after.
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.
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 same. You want greater return for taking risk. For you to get greater return, price of the bond has to go down (discussed in the next section).
#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, interest rate went up by 1%, 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, 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, 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 hands, 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 rate is cut) and fall the most (if the rate is hiked). With long term debt funds, 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.
Book Suggestion: Retire Rich, Invest Rs 40 a day (P.V.Subramanyam)
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 portfolio has evolved.
Just by looking at this information, you will get good idea about 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 Scheme Information Document too, which contains the information about where the fund manager can invest and the discretion fund manager enjoys.
Ultra Short Term Debt Fund (with relatively low credit risk)
Ultra Short Term Debt Fund (with medium credit risk)
Long Term Gilt Fund
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.
Unless it needs the money, it can afford to wait.
However, when there is huge redemption pressure (say in case of downgrade of an un bond), fund house may limit redemption. This is because 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 picture.
#4 Market Risk
This is Economics 101. If there is too much selling pressure, 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 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 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. After all, personal finance is personal.
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.
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