How safe are debt mutual funds?

A few years back I met a Corporate Treasury client who had invested significant sums of money into debt mutual funds. As we were discussing his portfolio, he asked me “How safe are debt funds?” At that point I realised how I had never really looked at debt funds from a “safety” lens. We do think about the risks in equity funds but rarely talk about the risks in debt funds. But before we delve further, let us understand what debt funds are.

Debt mutual funds are those which hold investments in instruments like government securities, bonds issued by corporates etc. They therefore have no exposure to “equity”. Also, debt funds normally earn a fixed rate of return on their investments and hence have lower risk as compared to equity funds. They are thus a preferred destination for low risk appetite investors. 

But debt funds like any other financial instrument do come with certain amount of risk. Let us understand some of them:

Interest rate risk: It refers to the risk of impact on prices due to change in interest rates. Assume you invest in a fixed interest security at 9% and after sixmonths the interest rate increases to 10%. But since you have a fixed interest security, you continue to receive 9% thereby making a notional loss of 1%. Now assume these securities are tradable. As a buyer, would you prefer to buy the security earning 9% or 10% one? Obviously 10%? But what if to ensure parity in the market, you have to pay more to purchase the 10% security? So essentially, as interest rates fall, higher interest paying securities become expensive and vice versa. This is what can happen with debt funds and are better known as interest rate risk.

Credit risk: It refers to risk of the credit worthiness of someone who has taken a loan (issuer of a debt security) and primarily depends on two factors — ability to pay and willingness to pay. Assume you gave a loan to a friend. Now your friend might be willing to pay yet unable to pay. Similarly, a corporate which has issued bonds (taken a loan) might fail to repay them back. This might lead to a downgrade in its credit worthiness (credit rating) and is better known as credit risk. The securities issued by the government enjoy the highest credit rating. Debt funds which have a higher exposure to lower rated bonds carry a higher amount of credit risk.

Liquidity risk: This is about how quickly we can liquidate a security in the market without impacting the price. It depends on the type of security one has invested in and the maturity profile of the investments. In India, higher rated securities are generally more liquid than lower rated ones. Also, long term securities are relatively less liquid than short term ones. Debt funds with higher exposure to short tenor instruments (Eg: money market securities) are relatively more liquid since the fund manager can cater to redemption requests more easily.  

Re-investment risk: The risk refers to the situation where the re-investment opportunities are available at a lower rate than that of the original investment. Assume you invested in a one-year fixed deposit with an intent to reinvest the proceeds when they mature.

But at the time of maturity, interest rate falls. You would then have to reinvest at a lower rate of return. Debt funds with investments in short term instruments have a higher reinvestment risk.

So debt funds do come with some amount of risk. The investment in debt funds should not be chased only for returns because the additional returns may be due to additional risk in the portfolio. The experience and expertise of the fund manager in evaluating the credit quality is also an important consideration.

The debt funds should be recommended according to the risk appetite of the investor keeping in mind the important parameters of liquidity, safety and returns of the debt investments.

(The writer is co-founder, CAGRfunds)