Debt funds are basically a type of mutual funds in which the investment is made in both assets viz. debt and fixed income. A debt fund can invest in long-term or short-term bonds, money market instruments, security products, or floating rate debt. If you are looking for an investment in debt funds then it is very important to know what risks are involved in such funds, before investing the amount. We will clear the doubts regarding such funds.
- What is Interest Rate Risk?
With reference to debt funds, the impact on returns is governed by interest rate risk. It depends upon the time period for which the investment is done by the fund manager as the investment is often done as per the present rate however the rates are supposed to change with time. The rates usually lower when the economy declines however they increase with advancement in the economy. With higher interest rates, the bond value is lower and vice versa.
The chances/ degree of fluctuation in interest rates depends upon the time period of investment. The fluctuations are likely to be more if the tenure is long.
- Does the Credit Rating of the Company Have Any Effect on Debt Funds?
Yes, absolutely. If a company has issued debt instruments and it makes irregular payments or does not pay, the credit risk arises. In case such default exists in any of the stocks presents in the fund, there is an adverse effect on the value of the fund which is decided by the weight of such fund in the fund’s portfolio.
- What is a Credit Rating?
A credit rating is a rating awarded by the certified credit agencies to a financial institution based on the capability of the fund to finance debt along with the fund’s cash flow. It is given by credit rating agencies like ICRA, CARE, CRISIL, etc.
Corporate bonds bearing a rating of AAA are supposed to be more secure as they have near to zero payment default risk and hence, are considered to be secure enough to invest without giving a second thought. The fund manager keeps an eye on the changes in credit ratings of the securities of the debt fund.
- Importance of Concentration and Liquidity in Debt Funds
Do not be afraid of these core finance terms. Actually, they are very easy to understand. Let us tell you how it works. Concentration is termed to be the portion of holdings of an investor in a specific bond. The risk is high when the holding proportion is high. For example, if you have an exposure of 10% in a specific security, now in case of any default, the NAV (Net Asset Value) of your fund may decrease by 10%. It is the duty of the fund manager to make sure that the debt fund is quite liquid in nature so that large value redemptions can be managed easily without impacting the NAV of the scheme adversely.
We are pretty sure you have got the idea of risks involved in debt fund investment, isn’t it?