Investing in debt mutual funds are considered to be the safest, and is compared on par with fixed deposits in terms of risk standard. But, do you know, debt mutual funds also carry risks which affects the overall performance of the investment. Debt mutual funds are subject to various kinds of risks, such as:
- Interest Rate Risk
- Default/Credit Risk
- Liquidity Risk
- Market Risk
Of the above-stated risks, interest rate and credit risk are the most significant risks and can be managed through proper risk analysis. Liquidity and Market risk are more of a macro situation, which you cannot control and the only option you have is to wait for the dust to settle down.
Interest Rate Risk
This risk plays a very crucial role in determining the return of the fund. Short term debt funds and liquid funds have the least effect of change in interest rates. Whereas, long term debt funds like dynamic bond fund and gilt funds have higher exposure to interest rate risk. In a falling interest rate scenario, the funds will be in higher demand as it offers higher returns, thus pushing up the NAV of the fund. The case is just the opposite for rising interest rate scenarios.
Credit risk means if a bond in the portfolio defaults or fails on interest payment on schedule date, the investment in the bond will just turn junk. In the recent case of DHFL, where it failed to pay the interest obligation, AMCs wrote off 75-100% value of the investment in DHFL bonds, which resulted in NAVs of the fund go down by over 50 per cent.
Funds with higher corporate debt exposure are more exposed to such a kind of risk than funds which have sovereign debt papers.
How to Analyze Risks in Debt Funds
Most of us are fairly unaware of how to analyse risks in debt funds, as its completely different from equity funds. There are two important parameters on which debt funds are analysed, that are:
- Average Maturity
- Modified Duration
As the fund has various debt securities in its portfolio with different maturity dates, the average maturity period is calculated to ascertain, in how much time the fund’s investment will mature.
The average maturity is the weighted average of the current maturities of all debt securities held in the fund.
The average maturity of a fund represents interest rate sensitivity. Longer the maturity period, higher will be the interest rate sensitivity.
Short term debt funds are best analysed through average maturity period and always look for a shorter duration, in order to minimise the effect of volatility.
Modified duration is more complex than average maturity. Modified duration in a fund expresses the measurable change in the value of a security with respect to change in interest rate.
For example, if the modified duration of the fund is 5 years, then it signifies that a per cent change in interest rate would change the value of the security by 5 per cent.
Modified duration is more useful in analysing long term debt funds. Liquid and short term debt funds will have near to zero modified duration. All fund managers aim for a shorter modified duration, in order to yield higher returns on investments.
Examples of modified duration in different kinds of funds:
- Gilt Funds have a higher interest rate sensitivity as it has a higher modified duration
- Dynamic bond funds continue to adjust their modified duration as per the interest rate cycle and keep the modified duration lower
- Liquid funds have nil duration risk, as all the investments are made in shorter duration treasury bills like 90 days, 180 days etc.
If understood, the risks in debt funds can be easily managed and you can earn a higher yield on your investments. Systematic risk and liquidity risk can affect your portfolio negatively, but you will get enough time and indications to cash out from the investments.