Debt mutual funds are those which are said to have a low risk of market volatility as they invest in fixed income instruments like bonds, deposits and money market instruments. Thus, debt mutual funds are preferred by investors who do not like market risks and want stable returns on their investments. That being said, it is a mistake to believe that debt mutual funds do not carry any risk at all. The returns offered by debt mutual funds are not guaranteed because these funds are also exposed to certain risks. So, when you invest in debt fund online, you expose your investments to such risks. Do you know which risks are associated with debt mutual funds?
Debt mutual funds basically have two types of risks – credit risk and interest rate risk. Let’s have a look at these risks in details –
What is credit risk?
Credit risk is also called default risk. It is the risk of default of realisation of the invested deposit. Debt mutual funds invest in bonds and money market instruments which promise a guaranteed rate of return on investment. These instruments also have a maturity period after which the invested money is returned. If, however, the instruments fail to return the deposit or the interest thereon after maturity, it would be a default and the risk of non-payment of the deposit is called the credit risk or default risk.
Credit risk of a debt instrument is measured by credit rating agencies which rate the instruments based on their repayment capacity. The ratings can be AAA, AAA+, AAA-, B, D, etc. The higher the rating the lower would be the credit risk. Thus, fund managers try and pick debt instruments which have a high credit rating so that the credit risk of the portfolio is minimized. Moreover, if the instrument carries a high credit risk, it would also offer a higher return. So, if you are investing in a debt fund online which has a high return, you should check the credit rating of its underlying assets.
The credit rating of instruments is done periodically and if the rating of an underlying asset falls, the value of the asset also falls, which, negatively impacts the debt fund portfolio.
What is the interest rate risk?
Interest rates on debt instruments are not fixed. They are dynamic in nature which changes with the changing economic conditions. If the interest rates rise in the markets, the market price of the bond falls and vice-versa. Since debt mutual funds invest in bonds, a fall in the bond price reduces the fund’s value and the returns are reduced.
So, when you are looking for the best debt fund, consider the interest rate risk of the fund vis-à-vis the modified duration. The concept of modified duration is used to measure the price sensitivity of the bond with a specified change in the interest rate. When the change in the rate of interest is multiplied by the modified duration, the expected change in the price of the debt fund can be ascertained.
To invest in the best debt fund, choose funds whose portfolio has lower weighted average maturity duration. Such funds carry a lower interest rate risk than funds whose portfolios have a longer weighted average maturity duration.
Factors which determine the credit risk and interest rate risk in a debt fund include then following –
Repo rate – if the repo rates fall, the value of the debt fund portfolio rises
FII investment – if there is a heavy FII investment in debt instruments, the value of the debt fund portfolio would rise
Domestic and international economy – economic factors directly impact the interest rates on debt instruments. They, therefore, directly impact the interest rate risk carried by debt mutual funds
Bear in mind these risks inherent in debt mutual funds when you invest in them. To invest in a debt fund online you can download the ETMONEY APP. It is a personal finance app which allows you to invest in the best debt fund. You can compare the performance of different debt fund online through this personal finance app and then choose one which offers the best returns at minimal risks. You can also invest online with minimal hassles at zero commissions and start your debt fund investments instantly. So, know the risks of debt funds and then invest in them through ETMONEY’s personal finance app for ease and convenience.
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