If you’re looking to invest in Debt Mutual Funds, we’ll tell you all about the associated risks and how you can hedge yourself against them.
We Indians like to play safe and be prepared for all contingencies. We are the world’s best hoarders after all. Look under a pile of clothes in our cupboard, under mattresses and in old chests and there’s a good chance you’ll always find money stowed away. Keeping up with this spirit, we Indians took to Fixed Deposits like ducks to water. They offer a decent rate of interest and are as safe and reliable as the lockers in our homes.
Then we got introduced to Debt Mutual Funds. They work like Fixed Deposit schemes and, if handled the right way, can offer better returns. Debt Mutual Funds come with medium to low risk. Your money is invested in fixed-income instruments like bonds and Gilt Funds, which carry lower risk than equities/ stocks. However, Debt Mutual Funds are not entirely risk-averse.
Additional Reading: Why Debt Funds Are A Good Investment For Beginners
This article talks about the risks associated with Debt Mutual Funds and how you can hedge yourself against them. We’ll also tell you a few things you need to look out for before and after you’ve invested in them.
Let’s start with how you can protect yourself against any potential risk.
- Interest Rate Risk
Debt Mutual Funds are closely tied to interest rate movement and have an inverse relationship with it. When interest rates rise, the value of your Debt Mutual Fund falls and vice-versa. Keeping an eye on the economy will give you a sense of the direction in which interest rates are likely to move. When the economy improves, interest rates fall, while during an economic downturn, interest rates rise.
Now, when you invest money in a Debt Mutual Fund it is diversified into different securities. Hence, when a debt security performs well, the net asset value (NAV) of the fund rises. Many fund managers take advantage of this situation by cashing out during a price rally. This way debt funds earn the interest money and also benefit from overall capital appreciation.
Another way to hedge against interest rate risk is to invest in a Debt Mutual Fund for a short period of time as the interest rates will be less volatile. Investing in a Debt Mutual Fund for the long-term leaves it vulnerable to interest rate volatility.
It’s important to know here that when you invest in a Debt Mutual Fund for less than three years, the gains are added to your other incomes and taxed as per the relevant bracket. However, when the tenure goes beyond 3 years the gains fall under capital gains category, which carries a smaller tax rate.
Additional Reading: An Introduction To Debt Funds And How To Benefit From Them
- Credit Risk
Debt MFs come with a credit rating. The credit rating indicates the ability of the portfolio to withstand a shock if the debt is not returned to a certain security within the portfolio. Hence, before you invest in a Debt MF, always check its credit rating.
A credit rating of AAA, A1+ or P+ is good and you can rest assured that your money is in safe hands. The impact a certain security will have on a Debt MF portfolio will depend on the weight of that security within the portfolio.
Now, you might ask why all portfolios can’t go in for AAA or similarly rated securities. This is because some of the lower rated securities offer bigger returns than higher-rated securities. Fund managers sometimes take the risk to get more returns on the fund. More returns are good for the overall portfolio and can send the NAV soaring.
If you don’t want to take a lot of risk with your investments then look at the rating of your Debt MF before taking the plunge. Also, don’t invest your entire savings in one kind of Debt MF. Break up your money and invest in Debt MFs with varying risk levels. So, even if you lose money in one you make up for it by gaining in another.
Additional Reading: How To Choose A Viable Debt Fund
- Liquidity and Concentration Risk
When you invest in a Debt MF your money is diversified into different securities. The amount each security holds in a portfolio determines its concentration within the portfolio. If a security with a high concentration does well, the entire NAV will rise.
On the flip side, if the security underperforms, the NAV of the portfolio will fall as well. Always look out for the concentration of various securities in a Debt MF. Then also look for the credit ratings of each security. This will give you a good idea of how much risk you are exposing yourself to.
Debt MF liquidity means the ability of a fund to move in and out of a security without majorly disrupting the NAV of the portfolio. Fund managers often do the juggling of moving from one security to another to get the best returns. Ask your fund manager to give you a low down on the liquidity status of your fund.
Sometimes, some investors might cash out their gains from the fund. This too affects the NAV of the fund. A good, secure fund will be able to withstand such redemptions and more than make up for it.
Factors that impact Debt Mutual Funds
- Repo Rate: Bonds are an important Debt Fund instrument. Bonds are closely linked to the Repo Rate. Hence when the Repo Rate falls, the NAV of Debt MFs rises. Keep your eyes and ears open to what the RBI says about the Repo Rate to know the future of Debt MFs.
- FII Investment: Di you know that Foreign Institutional Investors (FII) invest more in Debt MFs than equity MFs. Is this good news? Yes, it is good news. FIIs invest big amounts thus sending the Debt MF NAVs skyrocketing. This also means that if the FIIs decide to withdraw their investments due to any reason, the funds will come crashing down. Keep reading about FIIs and know where they are investing.
- Global and local economy: Keep yourself abreast of all that is happening in the Indian economy and the global economy. We mentioned before that interest rates actively respond to the direction in which the economy moves. Knowing what turns the economy might take next will allow you to take precautionary measures ahead of time. Keep an eye on inflation in particular.
Additional Reading: Why You Should Re-evaluate Your Debt Fund Strategy
This was all about Debt Funds and the risks associated with them. If you found this article helpful do leave us a comment in the comments section below.