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Five Risks you must know about debt funds
September 15, 2009

Thinking about investing in a debt fund? Make sure you know about these five risks and how they affect the assets held in debt funds before you invest your hard-earned money


Author : iFAST Research Team



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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
Table 1: Typical Credit Rating System
AAA Highest Safety
AA High Safety
A Adequate Safety
BBB Moderate Safety
BB Inadequate Safety
B High Risk
C Substantial Risk
D Default or Expected to Default
Source: iFAST Compilations
Ratings Downgrade Risk
 

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.


Chart 1: Yield Curve Risk

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.

iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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