BT Insight: Interest rate, credit and concentration risks in debt funds that you must know about

The ongoing liquidity crisis in the NBFC sector is a vicious one. The delayed payment by Dewan Housing Finance Corporation (DHFL) on its non-convertible debenture (NCD) last week, a slash in its credit rating for short-term papers and a resultant mark-down of net asset values (NAVs) by mutual funds - as mandated by mutual fund association AMFI - has intensified troubles for other NBFCs, whose borrowing power is getting weaker by each passing day. While the Reserve Bank of India (RBI) has cut policy rates three times in a row, the transmission is missing. Besides, since banks have sectoral caps and the debt market is seeing outflows, the revival of the sector would be a daunting task. However, it should not bring a bad reputation to debt funds. Investors need to understand the risks and rewards clearly instead of shunning debt funds in a hurry.

"Often investors chase yields and hence compromise on the quality of the portfolio. They should identify debt schemes on the basis of their investment objective and risk profile. The critical learning out of the current episode is that it throws light on the credit-risk associated with debt funds that was largely ignored by investors earlier," says Devang Kakkad - Head Research at Equirus Wealth Management.

Below is a handy guide to debt funds and some of the key risks involved in debt fund investment:

What are debt funds?

Debt funds are such MF schemes that invest in money market instruments such as corporate bonds, treasury bills, government securities and commercial papers. Since these instruments are relatively safer, the risk of loss reduces as compared to the same investment in equity funds.

Multiple debt funds invest in different instrument types for varied maturity periods. For example, liquid funds invest in treasury bills and government securities and the holding period could be as low as one day. Corporate bond funds invest in papers issued by corporations for at least 1-4 years. There are short-term and ultra short-term debt funds, dynamic bond funds, gilt funds and fixed maturity plans as well.

Key risks

Interest rate risk

The interest rate trajectory of the economy affects the bond price and thus the NAV of the debt fund. The bond price and NAV go down if interest rates are rising, while they go up when interest rates decline.

Financial Literacy Expert Varun Malhotra, who is also the founder of EIFS, explains it well: Debt funds with long average maturity do extraordinary well when interest rates go down fast. Since newer investments deliver lower yields in lower interest rate regime, higher yield bonds held by the fund bought earlier become very attractive and their market prices go higher, leading to higher NAVs and very attractive 1-3 year returns. The investors feel that these funds usually deliver higher returns and invest in them, without understanding that when the interest cycle changes and interest rates go up, the market price of previously held higher yield bonds will go down drastically taking NAVs and returns very low.

Since getting the correct sense of interest rate regime requires skills and involves risks, tactical players may take advantage of falling interest rate regime by investing in longer duration bonds such as gilt funds. A know-nothing investor, however, would do well to invest only in funds with lower average maturity.

"The best way to avoid the interest rate sensitivity risk is by investing in debt funds that have lower average maturity i.e. an ultra-short term fund or liquid funds. Liquid funds for the investment where you require easy liquidity and ultra-short term fund as a replacement for bank FDs," advised Malhotra.

Credit risk

Credit risk in debt funds is the possibility that the issuer of the security may not pay back i.e. default at the time of repayments. A few debt funds such as credit opportunity funds and corporate bond funds (also called accrual funds) invest in lower-rated securities with a higher probability of default because they offer attractive yields. If the credit call goes wrong - as happened in the case of IL&FS and DHFL - the debt fund will have to take a haircut i.e. writing off the principal amount and the interest, which reflects in the value of the NAV.

Hence, credit risk could be rewarding in good times but can deliver massive blows when credit call goes wrong.

Concentration risk

Investors should also analyse the portfolio segregation across securities. Among the recent worst hit debt funds, Malhotra says, the percentage exposure of total assets to debt of one or two companies was huge. "The investor should look into the top holdings before investing in the scheme and should keep reviewing those on a quarterly or annual basis. Irrespective of how comfortable the investor is with the name of the company in top holdings, the idea is to have a well-diversified debt fund. The exposure should not be more than 3 per cent or so to a single company's debt," he says. Liquid funds and ultra-short term funds do a decent job at managing this risk, he adds.

What not to do

Don't run after higher yields

Most investors invest in debt funds in the want of higher returns than FDs, predominantly chasing higher yield-to-maturity (YTM) of the funds. However, this is the wrong approach. Debt funds should be viewed as a place to park money in a more tax efficient way as compared to FDs and not as an instrument to earn higher returns. "Higher returns will finally come because of their better tax treatment and not because they have invested in high yield (interest) bond," explains Malhotra.

Investors can add short-term capital gains (STCG) from debt funds to total income, which will be taxed as per the income slab. A fixed 20 per cent tax after indexation applies for long-term capital gains (LTCG) from debt funds.

Don't run after the past performance

Shweta Jain, Founder at Investography points out that investors should not bet on future performance by judging the past performance. "When investing in debt funds, we should look at two things: Safety and liquidity. However, when we only look at past performance, we don't get the correct picture. The things one should focus on are: research process, risk assessment, type of fund and what kinds of risk are associated with the fund and of course, the fund manager."

Where to invest

Unlike equity investment, where the long-term approach is appreciated, debt investment should be avoided for long-term goals as longer the investment horizon, the higher the uncertainty on the interest rate and credit risks. At most, the duration to invest in debt funds should not be longer than four-five years, experts say.

Mahendra Jajoo, Head-Fixed Income, Mirae Asset AMC advises investors with medium-term investment horizon to consider short-term bond funds and those with long term horizon and an asset allocation approach should look at dynamic bond funds or bond funds. However, high credit quality portfolio should always be the first choice in all cases, he emphasises.

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