Know The Risks To Your Debt Funds

Is it safe? That’s what people want to know when they talk about default risk in investments. Let us state one basic aspect for the sake of clarity. A mutual fund is a vehicle for investors to participate in the market, for example, equity market or bond market or gold. It may seem that you are investing in a mutual fund, but actually you are investing through the mutual fund in these instruments. The difference between “in” and “through” is that when you are buying, say, an equity stock or bond, you are investing in it. When you are participating in an investment vehicle, for instance, a mutual fund or a portfolio management service (PMS), you are investing through that vehicle.

The relevance of the difference is that when you are thinking about the safety of your money, it is related to the structure of the vehicle, i.e., the mutual fund, and how strongly it is regulated. In that sense, the way mutual funds are structured, makes them a safe investment vehicle. The securities, equity shares or bonds, that are purchased with your money, are kept with a custodian, and the responsibility to ensure safety lies with the trustees.  

We are used to discussions about the asset management company (AMC), which is the entity that has the responsibility of the day-to-day running of funds, including managing your money. The AMC, however, does not own the securities; they are the managers who are acting as the agent of the investor. Then where is the risk?

The risk lies in the market. Price fluctuations or any other event can happen any day. To give an illustration from equity, in the period January to March 2020, during the initial phase of the pandemic, equity market indices fell by almost 40 per cent. Some equity funds would have eroded more and some less, depending on the portfolio composition. The AMC can only do so much. But your money was safe; when the market rallied thereafter, your fund value would have gone up as much. There are similar instances in debt too.

What Are The Different Facets Of Debt Market Risk?

Among the major risks that debt funds face are bond market volatility, issuer default, portfolio concentration, unknown events and lack of liquidity.

Volatility: Price fluctuations in the market occur in bonds as well, though to a lesser extent than in equities. These fluctuations lead to interest rate risk, market risk or volatility risk. Interest rates and bond prices move inversely. When interest rates in the market are moving up, the impact on your debt fund investments is adverse, and vice-versa. The mitigant to this is your holding period: it should ideally match the fund’s duration and your money should be invested into debt funds of various maturity buckets.

An illustration of this volatility or interest rate risk can be seen in the most extreme move inflicted on the market till now, which was in July 2013. The Reserve Bank of India (RBI) raised interest rates significantly and squeezed the banking system’s liquidity. As a result, all debt mutual funds, including liquid funds, yielded negative returns for some time. Another example is the second half of 2008, when the global financial crisis was breaking out and the market was expecting interest rate reduction by RBI. In a few months, debt funds yielded double-digit returns, similar to a rally in equity.  

Default: It may sometimes happen that issuers of debt instruments don’t pay back the interest or maturity proceeds on time. This is also known as credit or default risk. There have been some well-known issuer defaults for example, IL&FS, DHFL, etc. As a precaution against this risk, look at the credit rating of the instruments in the portfolio. Obviously, the higher, the better. AAA is the highest credit rating, followed by AA and so on. While IL&FS, DHFL were AAA-rated securities, one must remember that a default can happen irrespective of high ratings, though a AAA-rated paper defaulting is extremely rare. Thankfully, the spate of defaults have stopped now. Many companies maintained their profitability and reduced debt during the pandemic. Moreover, economic recovery has gathered steam, and the apprehension of pandemic-induced defaults is almost over. This is indicated in credit rating agency reports, where more companies have been upgraded than downgraded.

Concentration: This is an indication of how well spread the portfolio is. It is another aspect of credit risk. The experience of IL&FS and DHFL defaults shows that though exceptional, even highly rated issuers can potentially default. If a debt fund portfolio is well spread out, the concentration in one security is that much lower. If something were to go wrong in one instrument, your stake is limited to that extent. For instance, a debt mutual fund with 10 per cent exposure and another with 2 per cent exposure to IL&FS both would have taken a hit. But the impact on the second fund would have been much less. To mitigate the concentration risk, while investing in debt funds, download the factsheet or portfolio from the website of the AMC and see how diversified the portfolio of your fund is.

Event Or Liquidity: While there are “known” risks like the ones discussed above, there are many unknown ones too because anything can happen in the market. In April 2020, when Franklin Templeton shut down six debt funds due to lack of liquidity in the secondary bond market, it created a fear psychosis among debt fund investors. The funds’ closure was perceived as a credit or default risk; people thought that the instruments in the funds’ portfolios were junk and hence the funds were shut down. However, it was, in fact, a liquidity issue as the funds faced significant redemption in March and April 2020 since the bond market at that point was not absorbing much of bond sales without impacting the price.

At present, SBI Mutual Fund, which was appointed by the Supreme Court of India as the administrator for liquidating the assets of the six closed funds, has given back 103.5 per cent of the money due to investors, taking April 2020 as the base amount. The remaining value in the portfolio of these funds and cash adds up to 109 per cent of the amount as of April 2020. This underscores the earlier statement that mutual funds as a vehicle are robust. But incidents can take place anytime in any market, be it equity, bonds or commodities.  

Conclusion

The basic reason you invest in debt funds is that returns are relatively stable than in equity, though also lower than equity. That premise remains intact. From time to time, your mutual fund statements or media headlines may show something you do not like. Do not get disturbed. Your confidence about debt funds or fund houses should not be shaken by once-in-a-century black swan event like the pandemic and economic shutdown. Regulation of mutual funds by the Securities and Exchange Board of India (Sebi) is strict and you are in safe hands. Market cycles will play out but get taken care of over a period of time.

The writer is a Corporate Trainer and Author