Debt Funds are Also Susceptible to Risks

By BankBazaar | May 11, 2012

Investments and savings are broadly categorized into 3 categories. The first category are those investors who want to benefit themselves by trading online and try to earn profits on a daily basis. The second category of investors prefers to invest in passive trading, the best option being Mutual Funds. A systematic Investment Plan (SIP) route is sought after whereby, your portfolio shows magnified returns over the end of a long tenor. The third category of investors is those who are not willing to take too much risk on their hands and opt for debt funds. However, debt funds are not entirely risk-proof and come with their own set of hazards. These funds consist of a portfolio that is constructed of several fixed income instruments, which are highly influenced by fluctuations or variations in economic indicators such as rise in the rate of inflation, balance of payments, government deficits, or long-term and short-term rates of interest. A fund manager may be prone to several risks via debt funds such as credit risks. These risks arise from the possibility that the issuer of such a debt instrument may not be able to repay the principal amount on the date of maturity, or may not be able to pay the interest at regular intervals. An issuer’s credit worthiness is assessed on the basis of his credit ratings that are assigned by specific credit rating agencies. Lower his credit rating, higher will be his credit risk and vice-versa. Debt instruments like bonds are highly sensitive to fluctuations in interest rates. When there is a rise in the rate of interest, the value of the bond dips and vice-versa. A risk of reinvestment is also involved which arise primarily due to variations in the rate of interest. The probability that periodic cash flows from the bonds may be reinvested at a lower rate than the actual coupon rate of the bond, leads to a fall in the value of the bond. Marketability risks may also be involved as secondary markets are still quite under-developed in the country. As a result, debt instruments are easily exposed to several market risks, thereby hampering their chances of profitability. When there is a transaction involving debt securities, funds dealing with them are highly exposed to impact costs, which substantially influence the value of the fund.

In order to reduce such market risks, fund managers seek the use of derivatives. Derivatives, which help fund managers in hedging their positions, refer to specialized instruments that offer funds several opportunities when there is an occurrence of disproportionate gains. They help in reducing any form of losses involved in the debt and equity markets, but at the same time, they are not entirely risk-free, as they come with the disadvantage of disproportionate losses too.

Apart from this vital information another thing that you need to know is that, as prudent investors, one should link their goals to their investment. Mostly, due to lack of proper streamlining of one’s goals, a major portion of your funds are parked into assets. In cases where the assets in question are debt funds, the time to liquidate funds from these assets may be time consuming. And time might be a crucial requirement you might not have at hand at that particular moment. Getting into the hands of private lenders who charge scrupulous rates of interest on the loans they provide or signing up for a loan with a bank since it is quite easier these days to avail one, will only add up to the burden on your finances at a later date, since you will be entitled to pay the EMIs and clearing them off before their tenor, which may also mean that you will have to bear the prepayment penalties.

In order to avoid such unwanted expenses, make sure that you park certain portion of funds into liquid assets like a Savings Bank account where your money does not lie idle but there is an interest rate addition. In case of any unforeseen circumstances this money can be utilized without liquidating your assets.

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