Debt funds carry indexation benefits and hence are more tax efficient than FD’s. Many financial planners recommend debt funds as a replacement for FD’s. However the debt funds do carry certain risks.
And it makes sense to be aware of those risks.
Investments in debt funds are subject to various risks like credit risk, interest rate risks, liquidity risks, market risks, reinvestment risks etc. Let us look at what these risks mean and how understanding these risks can make you a better investor.
1. Credit Risk : This refers to the risk that the issuer of a fixed income security may default (which means that, he will be unable to make timely principal and interest rate payments on the security)
2. Interest rate risks : This risk results from the change in demand and supply of money and other macroeconomic factors and creates price changes in the value of debt instruments. Hence, the NAV of the scheme may change due to the fluctuations. Prices of long term securities generally fluctuate more in response to interest rate changes than do short term securities. Thus, this risk may expose the schemes to capital erosion.
3. Liquidity Risk : This refers to the ease with which the security can be sold at or near to it’s valuation yield-to-maturity (YTM).
4. Market Risk : Market perception of interest rate sensitivity, general market liquidity, credit worthiness etc. may cause price volatility and hence lead to capital erosion.
5. Reinvestment Risk : This risk refers to the interest rate levels at which cash flows are received for the securities in the scheme is reinvested. The risk is that the rate at which the interim cash flows can be reinvested may be lower that that originally assumed.
So, how do fund managers try to mitigate these risk factors :
a. Interest rate risk : By keeping the maturities of the schemes in line with interest rate expectations. (Note the key here is expectations, so if the expectations go wrong, the strategy can mis fire).
b. Credit Risk or Default Risk : By investing in high investment grade fixed income securities rated by SEBI registered credit rating agencies. Eg: investing in AA/A rated securities carry a higher credit risk compared to AAA rated securities. Note, historically, though , the default rates for investment grade securities (BBB & above) has been less.
c. Reinvestment Risk : This is limited to the extent of coupons received on the debt instruments, which will typically be a very small portion of the portfolio
d. Market risks : The schemes may take positions in interest rate derivatives to hedge this risk.
Understand the risks, become aware and deal with these risks to make informed decisions towards building wealth.
You can read more about debt mutual funds here.