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Are Debt Funds Really Risk Free?

In this article, we bring forth the risks associated with investing in debt
funds and their impact on performance.
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By Himanshu Srivastava | 06-09-13

About the Author


Himanshu Srivastava is a Research Analyst with Morningstar. He would like to hear from you, but cannot give financial
advice.
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In India, debt funds have traditionally been considered to be low risk investment
avenues. Expectedly, this has led to them being considered as apt investment avenues
for risk-averse investors. However, the way domestic fixed income markets have
behaved over the last few months (and in turn, their impact on performance of debt
funds) has forced many to revisit their thinking.
Typically, investors focus on the risk aspects of debt funds tends to be low. However, the
fact remains that investing in debt mutual funds entails taking on some inherent risk,
which an investor should be aware of. And the time to spread this awareness couldnt be
more apt with the domestic fixed income market witnessing an extremely turbulent
phase.
In this article, we bring forth the risks associated with investing in debt funds and its
impact on their performance with a view to help investors make informed investment
decisions.
1. Interest rate Risk
Interest rate risk is one of the most prominent risks to which debt funds are exposed to.
It refers to a change in the price of a bond due to the change in the prevailing interest
rate. Hence, it directly impacts bonds and subsequently debt funds. For instance, a rising
interest rate scenario is a positive for funds having a shorter maturity profile; whereas a
falling interest rate scenario is a positive for funds having a longer maturity profile.
Simply put, higher the maturity profile of the fund, more prone it is to interest rate risk.

Interest rate risk is mainly measured by duration, which is a measure of the sensitivity of
a bonds price to interest rate movement. Higher the duration of the bond, more its price
will tend to fluctuate with the change in the interest rate.
Let us now understand the impact of interest rate risk on the performance of various
domestic debt funds. In India, the movement in interest rate has a close proximity with
the countrys inflationary scenario. During rising inflation, the Reserve Bank of India
(RBI) hikes interest rates (to check inflation) and vice-versa. Starting from the year
2010 till August 31, 2013, the country has witnessed both - rising as well as falling
interest rate scenarios. The table below shows the impact of changing interest rate
scenario on the performance of various debt fund categories. For this we have
segregated the aforementioned period into three distinct phases, based on different
stages of interest rate in the country.

Phase 1: Rising Interest Rate scenario (January 2010 - October 2011)


This was the period marked by high inflationary pressure. To bring inflation under
control, the RBI went on a rate hike spree. Consequently, the returns from long-term
bond funds were lower compared to liquid, ultrashort and short-term funds.
Phase 2: Falling interest rate scenario (Nov 2011 - June 2013)
In its guidance in the monetary policy announced on October 2011, the RBI not only
indicated a pause in rate hike but also hinted at a cut in interest rates going ahead.
Since then till August 31, 2013, the RBI cut repo rate by 125 basis points. This
benefitted long-term debt funds as indicated by the returns delivered by Long-Term
Government Bond, Intermediate Government Bond and Intermediate Bond categories.
Phase 3: Change in interest rate scenario due to rupee volatility

Over the last few months, the rupee has witnessed intense volatility and massive
depreciation in its value against the dollar. The depreciation in the rupee makes imports
costly thus putting an upward pressure on inflation. Not only are there doubts about
further rate cuts this year, but there is speculation regarding rate hikes. This sudden
change in the scenario has led to a reversal in market dynamics thus impacting debt
funds adversely, especially long-term debt funds.
Hence, investors on their part would do well to fully comprehend how debt funds react
under different interest rate scenarios before investing in them.
2. Credit Risk
Credit risk refers to the credit worthiness of the issuer of a bond. It applies to corporate
bond funds since government bond funds do not carry credit risk as they are issued by
the government. Credit risk takes into account whether the bond issuer is able to make
timely interest payments and also the face value at the time of maturity of the bond. If
the issuer is unable to do so, the bond is said to be in default. This brings down the
credit rating of the issuer of the bond thus raising doubts on the entitys credit
worthiness. A downgrade in credit rating will cause the bonds price to fall, in turn,
negatively impacting the performance of the bond funds holding it.
The chances of credit downgrades are high during an economic downturn. Further,
leveraged companies (companies which use debt to finance operations) are especially
more prone to credit risks. Investors should be cautious while investing in funds having
high exposure to such companies. Investments in funds with high credit risk should be
made only if investors have the appetite for the risk associated with such funds.
3. Liquidity Risk
Liquidity is the ease with which a fund manager can sell a particular security in the
market. A fund faces liquidity risk if the fund manager is not able to do so due to lack of
demand for the security. Broadly speaking, the debt market in India is still not well
developed. There are very few players in the market with majority being institutions.
Furthermore, retail participation in the debt segment of mutual funds is very low.
The domestic debt market is comprised of the government bond, corporate bond and
money market segments. While the government bond and money market segments
enjoy high participation thus making them liquid in nature, the participation in corporate
bond segment is still low. Further, corporate bonds which have high credit ratings witness
much higher demand from investors than comparatively lower rated bonds, thus making
them more liquid. Hence, during a downturn, when sentiment turns risk averse, funds
having illiquid papers typically find it difficult to stay afloat. Also, if faced with
redemption pressure, the fund manager may be forced to sell his papers at a significant
loss, which could adversely hit the fund performance.
Besides the above mentioned risks, at times there could be some unexpected events
emerging which could also hurt the performance of debt funds. One such instance of
recent origin is the rupee depreciation, and the impact it had on the debt funds across
tenures. Having said this, investors should know that movement in currency does not

have a direct impact on the debt markets and debt funds. However, any policy decision
taken in that regard by the central bank or the government could impact debt funds.
For some time now, the rupee has been weakening prompting the RBI to take measures
to bolster the rupee. A few such measures were taken by the central bank on July 15,
2013 when it increased the cost of short-term borrowing and squeezed liquidity from the
system. These measures were aimed at deterring speculation on the rupee. However,
these measures had a negative impact on debt markets.

As depicted in Table 2, on July 16, 2013, the day after the RBI announced measures; all
debt fund categories registered a sharp fall in returns. Indeed, even the 1-month return
as on July 16, 2013 for most of the categories (except for liquid and ultrashort bond
funds) entered into the negative territory. While the squeeze in liquidity and increase in
short-term borrowing rates dragged liquid and ultrashort-term bond funds down; fears of
no further rate cuts and speculation of a hike in interest rates pushed long-term bond
funds down.
What should an investor do?
Investment prudence demands that an investor must understand the risk/reward profile
of a fund (whether equity or debt) before investing in it. Lower risk in debt funds
compared to equity funds is no reason to ignore risks associated with debt funds. Debt
mutual funds, like equity funds, are market- linked instruments and hence do not give
any assurance of either returns or capital preservation. Hence, investments in debt funds
should be made after fully understanding the risk associated with them.

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