You are using an older browser version. Please use a supported version for the best MSN experience.

Know the risks when picking debt funds

LiveMint logoLiveMint 20-05-2014 Lisa Pallavi Barbora

With the election results out, the cheer in equity markets is there to see. But if you are a mutual fund (MF) investor, it isn’t just about getting equity exposure; fixed income investments also form a large part of the pie. In fact, income funds constitute 48% of the total industry’s assets under management (AUM), compared to roughly 20% for equity funds. Retail investors, however, are still not comfortable with this category.

According to data from Association of Mutual Funds of India (Amfi), as on March 2014, on the basis of AUM, retail investors are only 5.5% of the universe for liquid, gilt and debt-oriented funds.

While companies and high net worth individuals (HNIs) are comfortable with the risk-return dynamics of debt securities, individual investors are usually not well versed with it. This might partly explain their absence. It’s easier to analyse the default risk of a well-known bank (perceived to be close to nil) when it comes to a fixed deposit with a fixed rate of return rather than understand the dynamic net asset value (NAV) of debt funds.

But it’s important to understand the kind of risk that’s associated with debt funds. There are primarily two types that you should be concerned about—interest rate risk and credit risk.Paras Jain/Mint

Interest rate risk

Bond prices are inversely related to yields—as yields go up, prices fall. The yield we are talking about is market yield, which is not the same as the coupon offered by a bond; rather it measures the bond’s interest as a percentage of its market price.

At the outset, what you need to understand is that yields across various securities—corporate bonds and government securities—are linked to the overall level of interest rates in the economy, ‘spread’ between securities, and the demand and supply dynamics of the underlying security.

Bond yields usually rise in reaction to a high or increasing interest rate in the economy (at present measured by the Reserve Bank of India’s repo rate in India), as it means that raising debt funds is expensive. Rising yields lead to a fall in bond prices because essentially in an environment where rates are rising, you would rather switch to a new security that reflects the higher interest rate, than staying with an existing bond with a lower coupon.

This risk is higher in securities that have a longer time to mature. The opportunity loss in case of a bond which matures in, say, three months, is much less than for a bond that matures in, say, 10 years. Hence, the impact of a price fall in case of the latter will be more, and this is what bond ‘duration’ measures.

The opposite also holds true. Bond prices rise when yields fall. So, if the expectation is that rates are likely to be lower in the near future, bond yields tend to fall and prices rise as existing securities with higher coupons become more lucrative.

Even though rising yields are not good for bond prices, it makes sense for you to invest in bond funds when interest rates are at a peak.

“When rates are at the highest, historical returns are the lowest; but investors need to consider the expectations around overall interest rate direction.” said R. Sivakumar, head, fixed income and products, Axis Asset Management Co. Ltd.

This means that interest rate risk is high when the rates are rising rather than when they are at the peak; in fact, when rates are at a peak it makes for a good opportunity to invest.

Investing in bond funds, however, can’t be about chasing returns and past performance as interest rate expectations and movement is dynamic. Bond prices will not change based on fund performance in the last year or two.

Nishant Agarwal, senior director and head–products and family office advisory, ASK Wealth Advisors Pvt. Ltd, said, “Unlike equity, investing in bond funds doesn’t require emphasis on past performance. Two funds with very similar mandates can have varied performance depending on the fund manager’s expectations. What’s more important is the view on interest rate cycle and ensuring that the fund manager is also in line with that view.”

Credit rate risk

This is another crucial risk related to debt securities and is directly linked to the issuer of the security. Just like there are good and bad quality stocks, there is a qualitative parameter for bonds too. Fortunately, unlike stocks, in case of bonds there is a formal way to analyse this.

Bonds are rated by certified credit rating agencies on the basis of the entity’s ability to uphold its financial obligations or liabilities.

This rating, in turn, helps an investor understand whether she is buying a bond from a financially healthy and stable company or from one where the chances of non-payment are high. In other words, credit risk means the possibility of capital loss or default in future interest payments due to the issuers inability to generate the required cash flow.

The level of credit risk is only partially reflected through a formal credit rating. Not all bonds are rated, but if the risk of default is perceived to be high for a particular entity, the interest rate offered to bond holders will also be high. Rather, the bond holder will demand a higher interest rate from entities seen as risky.

If you want to earn high yields through bonds, you could invest in funds that invest in bonds rated lower than AAA or even AA. AAA and equivalent rating signifies the highest level of safety.

Bonds rated lower aren’t in bad financial health; they are worth investing in but may be at a stage of business where the ability to generate sustainable cash flows is yet to be recognized formally.

When an economy improves, fortunes of good quality companies can advance and the ratings often change positively to reflect that. This works to your advantage. The key is that the fund manager is able to sift through and identify such companies.

“There is merit in professional management of credit as investors on their own will not be able to identify good quality companies. But before investing, look at things like sector concentration and the average or median rating of the fund’s portfolio,” said Sivakumar.

Agarwal advises not allocating more than 20-30% of one’s short-term fixed income needs to such funds. “In that case, even if the risk plays out, your overall exposure is very low.”

What should you do?

First, keep in mind that when we talk about risk, it is the risk of change in price and subsequently the change in your MF’s NAV. Second, these aren’t the only two risks, but these two matter the most.

If you aren’t comfortable with the price swings that interest rate risk carries, choose funds with a relatively lower duration or a fixed maturity fund. You can use such funds for your strategic fixed income allocation. Venture into debt funds with high duration, like income funds and gilt funds, only if you understand the interest rate risk prevalent in the current market environment.

Credit risk, on the other hand, needs to be considered at all times. You may not have the time and the wherewithal to analyse an entity’s ability to repay your debt, and hence need to rely on the official credit rating. Or, you could depend on your bond fund manager’s ability to pick stable entities even if their rating is not the highest.

Thankfully, the entire spectrum of funds is available to retail investors. So, depending on your comfort and understanding of the two main risks, you can choose to invest in the most appropriate type of fund.

More From LiveMint

image beaconimage beaconimage beacon