Debt
funds managed by fund managers invest in bonds and debt
securities as their
underlying
assets. Investors keen to gain exposure to a debt fund should be aware
of the
five main risks that a portfolio of bonds is
exposed to.
Interest Rate Risk
Interest
rate risk is risk of change in a bond’s price due
to interest rate changes. As a rule of thumb, when interest rates go
up, the
value of a bond goes down. We can illustrate
this with an example:
Let’s
say the
interest rate stands at 4%. A bond with a coupon rate of 4% and face
value of Rs.
1000 will likely sell at par value. This is because a buyer of this
bond will
be indifferent between buying a bond and saving directly with a bank.
If
the
interest
rate surges by 100 basis points (bps) to 5%, then
bondholders with a 4% coupon rate will likely sell the
bond and keep the
money with a bank
account instead. This selling pressure will adjust bond prices
downwards.
Hence, at higher interest rates, bond prices will generally be lower.
Similarly,
if interest rates drop to 3%, the
4% bond coupon rate is more attractive than interest
rates and buyers will start buying this bond instead. The buying
pressures will
adjust the
bond prices upwards.
Hence, at lower interest rates, bond prices will generally be
higher.
Since
a debt fund consists of bonds as its underlying
assets, the
portfolio’s value will
react in a similar manner to interest rate changes.
Credit
Risk
Credit
risk, also known as default risk, is
the possibility of
a bond issuer failing to repay the
bond principle and interests in a timely manner.
In
India, there
are a few credit rating agencies that provide rating services for
bonds. A
typical rating system is shown in table 1
Debt funds usually provide a breakdown of their
portfolio holdings in their
regular factsheets. You will be able to find the
credit rating of the
individual
holdings for reference. For all funds available on Fundsupermart.com,
factsheets
are available off the website as well.
You can also read a detailed article on Indian Credit Ratings here
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Table
1: Typical
Credit Rating System |
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AAA
|
Highest
Safety
|
|
AA
|
High
Safety
|
|
A
|
Adequate
Safety
|
|
BBB
|
Moderate
Safety
|
|
BB
|
Inadequate
Safety
|
|
B
|
High
Risk
|
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C
|
Substantial
Risk
|
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D
|
Default
or Expected to Default
|
|
Source:
iFAST
Compilations |
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Ratings
Downgrade Risk
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Ratings
downgrade risk is the
risk that the
bonds will be
downgraded by credit rating agencies. It is important for investors to
note
that credit ratings issued by agencies are subject to revision. Why is
downgrade
of ratings considered a risk?
Consider
a triple-A bond with a 6% coupon currently selling
at Rs1000. Some investors will invest
in
the
bond because of its triple-A
rating, the
highest safety rating. If
the
triple-A bond is downgraded to
triple-B, the
risk-return ratio that
was
once attractive for current bondholders will now become
unattractive as the
risk has increased without an increase in
returns. Holders of this bond will sell the bond, causing downward
pressure on the
bond price.
A
debt fund portfolio is exposed to this form of risk when the
rating of the
underlying bonds is downgraded.
Downgrade risk can be offset partially
by diversification.
Yield Curve
Risk
The
yield curve shows the relationship between the
cost of borrowing and the
time to maturity
of debts of equal credit quality. A yield
curve representing India Government Bonds is represented as follows:
The
expected yield of bonds of a particular credit quality
is expected to follow the
yield
curve.
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| Chart 1: Yield
Curve Risk |
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Reinvestment Risk
Reinvestment
risk is the
risk of investment proceeds not being reinvested at previously
attractive
rates. To illustrate, a bond fund has underlying bonds with varying
maturities,
coupon rates and yields. Whenever, the
fund receives coupon payments or proceeds from maturing bonds, the
manager needs to seek out another
alternative to invest his proceeds. However, there
is a possibility that the
fund manager is unable to find an alternative that provide the
yields he receive previously.
This
risk is particularly relevant for bond funds investing
into short-maturity instruments and/or instruments with high-frequency
coupon
payments (for example, quarterly coupon payments), because the
fund manager has to look for alternative investment
opportunities on a more frequent basis.
Conclusion
Investors
of debt funds should be aware of these
five risks as bond funds are exposed to these
five main risks. With this awareness, investors can make better
decisions when
investing in bond funds.
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