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January 30, 2019

Balance your risks & rewards with debt funds

Debt mutual funds have emerged as a strong investment alternative to traditional fixed income instruments. Theability to generate mark-to-market (MTM) returns and indexation benefit for an investment horizon of over three yearshave catapulted these funds higher on the popularity chart than the traditional favourites - fixed deposits. Numberscorroborate this trend: debt mutual fund folios as a percentage of total individual investors folios increased to 14% inDecember 2018 from 7% in September 2009. While the recent rating downgrades and ensuing liquidity crisis might have caused some nervousness,investors should not get swayed but look at the portfolio of the underlying funds to map their risk-return profile.

 

What are debt funds?

 

Debt mutual funds are professionally managed, market-linked products that invest in money market instruments, bonds and government securities.There are several products within the category to cater to different risk-return profiles and investment horizon. However, since these are MTMproducts, they are subject to certain risks, which are detailed below.

 

Risks - Investments in debt mutual funds are subject to three primary risks – interest rate, credit and liquidity risks.

 

Interest rate risk is sensitivity of a fund’s portfolio value to the changes in the interest rate. It is measured by modified duration. Typically, higher thefund’s duration, more it is exposed to the interest rate risk. In fact, rise in interest rate adversely impacts long duration debt instruments. Longmaturity/ duration funds such as gilts are more exposed to this risk than short maturity funds such as liquid, ultra-short and short duration funds. Forinstance, gilt funds gained nearly 15% on an annualised basis in the declining yield phase of 2014-16 and gained only 3.7% on an annualised whenyields trended up recently. Moreover, selection of funds is important in the duration play as performance can vary widely based on the fund managers’view on the interest rate trend. For instance, when yields sharply corrected in 2008, absolute returns of funds in the category varied widely from a low of1.3% to a high of 38.6%. Hence, long maturity funds require more tacticalcalls for investors compared with short maturity funds.

 

Credit risk is the risk of default in payment of coupon and/or principal byan issuer. Lower the credit rating, higher the credit risk. Table 1 indicateserosion in value owing to a rating downgrade. It also shows that theportfolio is impacted more if a security, whose rating is downgraded, hashigher weightage in the portfolio, highlighting the concentration risk. Forinstance, a downgrade from AAA to AA for a security that accounts for10% of the portfolio can shave 53 bps off the returns, compared with 11bps points for a 2% exposure. Investors can limit these risks by choosingwell-diversified funds with higher exposure to high credit rating papers(AAA/ A1+).

 

Liquidity risk is the risk the fund is exposed to in liquidating the investedassets in case of dire circumstances. Analysis shows that the liquidityrisk increases as the rating of the invested instruments goes down (Table2). Thus, investors can reduce this risk by investing in funds with a higherrating.