funds managed by fund managers invest in bonds and debt
securities as their
assets. Investors keen to gain exposure to a debt fund should be aware
five main risks that a portfolio of bonds is
Interest Rate Risk
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
value of a bond goes down. We can illustrate
this with an example:
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
be indifferent between buying a bond and saving directly with a bank.
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
Hence, at higher interest rates, bond prices will generally be lower.
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
bond prices upwards.
Hence, at lower interest rates, bond prices will generally be
a debt fund consists of bonds as its underlying
portfolio’s value will
react in a similar manner to interest rate changes.
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.
are a few credit rating agencies that provide rating services for
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
holdings for reference. For all funds available on Fundsupermart.com,
are available off the website as well.
You can also read a detailed article on Indian Credit Ratings here
Credit Rating System
or Expected to Default
downgrade risk is the
risk that the
bonds will be
downgraded by credit rating agencies. It is important for investors to
that credit ratings issued by agencies are subject to revision. Why is
of ratings considered a risk?
a triple-A bond with a 6% coupon currently selling
at Rs1000. Some investors will invest
bond because of its triple-A
highest safety rating. If
triple-A bond is downgraded to
risk-return ratio that
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
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
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:
expected yield of bonds of a particular credit quality
is expected to follow the
|Chart 1: Yield
risk is the
risk of investment proceeds not being reinvested at previously
rates. To illustrate, a bond fund has underlying bonds with varying
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.
risk is particularly relevant for bond funds investing
into short-maturity instruments and/or instruments with high-frequency
payments (for example, quarterly coupon payments), because the
fund manager has to look for alternative investment
opportunities on a more frequent basis.
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
investing in bond funds.