Debt funds: Not always risk-free

Debt funds invest in instruments that carry a fixed rate of interest or are guaranteed, in many cases, by the issuer. As a result, debt funds are often perceived by the investor as being completely risk-free. However, the reality is different. Debt funds may be less risky than equity funds, but they certainly aren't risk-free. Debt fund NAVs can change with interest rates, changes in the portfolio's ratings or tenure.

There are two types of gains — one is the interest that a debt security accrues or earns which is also called the coupon; and the other is the capital appreciation which it earns due to a change in market interest rates. The following risks are associated with Debt Funds.

Interest rate risk: The price of the bond is not only based on the current interest rates but also the expected future interest rate. The NAV of a debt fund is calculated based on the price of the underlying bond/securities. If market interest rates fall, the price of the bond rises, thereby increasing the NAV and vice versa.

The extent of the fall or rise will also depend on the tenure of the bond the fund is holding. The longer the tenure, the more sensitive it is to change in interest rates. Assume a debt fund has invested in a certificate of deposit, which carries an interest rate of eight per cent and will mature in five years.

After a month, the central bank announces a cut in interest rates and as a result the same deposit is now available at say 7.5 per cent. What it means is that all fresh investments will earn 0.5 per cent lower. As the earlier deposit is earning 0.5 per cent more than the current rates the markets will pay more for the same resulting in an increase in valuation of the deposit, and thereby, increasing the NAV.

When the fund manager is expecting the rates to come down, he increases the tenure of the bonds that he is holding to increase capital appreciation and reduces the tenure, if he is expecting the rates to go up. That is why bond funds give higher returns when interest rates are expected to go down and lower returns when it is expected to go up.

If interest rate risk is one type of risk, bond funds also carry credit risk.

Credit quality: Most securities held by debt funds have a credit rating assigned by rating agencies, suggesting the ability of the security to meet its payment obligations. The higher the credit rating (P+ or AAA or A1+), the lower is the perceived risk of default, and hence, lower is the rate that one earns, and vice-versa.

Funds also take exposure in securities with lower ratings either to get higher interest rates or with the hope that the rating will be upgraded in near future. In case the rating of a bond goes up from say AA to AAA, there will be some capital appreciation resulting in increase in NAV. In case of a default, the NAV will come down as the money invested in the bond cannot be recovered from the company the fund has invested in. Therefore, it is important for an investor to not only look at the returns generated by the fund but also the credit quality of the portfolio.

Liquidity: It is important that the bonds invested in by the fund are liquid enough to be sold when the money is required. In case bonds are not liquid, they have to be sold at a discount, resulting in a lower NAV.

All the above risks are manageable and can be reduced if the investor is prudent in choosing his bond funds. If the surpluses that you have are for less than three months, you should be investing in liquid funds that have shorter portfolio tenure.

If you have the money for more than a year, you should be investing in funds with longer portfolio tenure or maturity like income funds. By doing this, you are aligning your investment objective with the fund's objective, and thereby, neutralising the volatility that the fund may go through due to any of the risks mentioned above.