Looking to invest in Debt Funds but you’re unsure about the risks involved? We’ll tell you how various financial aspects affect the performance of Debt Funds.
What are Debt Funds?
What is interest rate risk?
Interest rate risk impacts the returns of investors in Debt Funds. This risk comes into effect when fund managers adjust the maturity value of the investment based on present interest rates.
Interest rates usually spike when the economy is advancing and slump when the economy declines. Bond prices are low when the interest rates are high and vice versa.
The degree of price fluctuation depends on the tenure of investors’ holding. Fluctuation levels tend to be higher if the holding tenure is longer.
Remember that the interest rate risk factor applies to all Debt Funds, although to varying degrees. However, the interest rate risk is relatively low for Liquid Funds.
Additional Reading: What To Remember When Choosing The Right Debt Funds
Does the credit rating of a company affect Debt Funds?
Yes. A company’s credit rating does affect a Debt Fund. How? Well, a credit risk arises when a company that has issued the debt instrument does not make payments regularly. If such a default takes place, then that will have an impact on the fund, depending on how much weightage the fund has in the portfolio.
What is a credit rating?
A credit rating is given to banks by agencies like CRISIL, CARE and ICRA. These are the main agencies among several others. The ratings are awarded based on the fund’s capability to finance debt and the cash flow of the fund.
Here’s a tip: Any corporate bond with a rating of AAA is considered to be of the highest quality. These bonds will have almost no payment default risk and are quite secure to invest in.
A fund manager will periodically review changes in credit ratings of fixed-income securities in the portfolio of investors.
Importance of liquidity and concentration in Debt Funds
Uh-oh! Lost you there, did we?
Liquidity? Concentration? Don’t worry. This isn’t financial chemistry.
Concentration is the proportion of holdings an investor has in one specific bond. The higher the holdings in a certain bond, the higher the risk. Here’s an example: Let’s say you have 10% exposure in one security. In case there is a default recorded, the Net Asset Value of the fund might decrease by 10%.
A fund manager is responsible for making sure that a Debt Fund scheme is ‘liquid’ enough so that it can comfortably manage large value redemptions without adversely impacting the NAV of the scheme.
Now that gives you a quick understanding of the risk factors involved in Debt Fund investments, right?
Additional Reading: Why Debt Funds Are Better Than Fixed Deposits