The fall in the NAVs of some of your debt funds in recent times may have come as a rude shock if you had been under the impression that debt funds provide fixed returns and are safe. Just as equities are subject to market vagaries, debt funds too face risks, namely, interest rate risk and credit risk. But the good news is that it is not too difficult for you as an investor to contain these risks, perhaps better than with equities.
Interest rate risk
Yes, debt funds indeed invest in instruments that have a fixed coupon/interest rate. But then, these instruments are typically traded in the debt market. And their price fluctuates based on the interest rate movements/perceived rate movements.
Prices of instruments are inversely correlated to the rates. When rates move up prices fall and vice-versa. Why is this so?
Let us take an example of Bond B, which has say a coupon rate of 10% for 10 years and a face value of Rs 100. When market interest rates move to 11% (or fresh instruments come with a higher coupon rate), then bond B cannot reset its coupon.
Some investors also ditch bond B in favour of higher yielding bonds. In order to bring bond B’s yields in line with the higher market rate, the bond price has to dip to Rs 90.9 (Rs 10 interest divided by 90.9 will give a yield of 11%).
Essentially, in a rising interest rate, an existing bond price falls, if its own coupon rate is lower than the new market rate. This is what happened with long-term gilts on Friday, September 20, when repo rates were hiked by 25 basis points.
Conversely, when rates do ease, prices rally.
The outcome of this can be seen in the fluctuation in the NAV of your debt funds. Of course, in favourable scenarios, debt fund managers try to make capital gains, when they see appreciation in the NAVs, by selling instruments that have seen a price rally. This is why besides gaining from the coupon (called accrual) many debt funds make capital appreciation as well.
Overcoming rate risk
So how do you deal with this risk? One way of dealing with it is to go for short-terrn debt funds where the risk of a sharp fall is limited as the duration of the instrument is short.
But then if you are holding for the long haul then income funds/dynamic bond funds that have the flexibility to tweak their portfolio maturity in line with interest rate movements would be good bets. But in such a case, go for a fund that has a good mix of bonds, CDs and government securities and not just the latter.
Yes, there is always a risk that the fund manager catches the rate cycle wrong. If you cannot take that risk, then it may be better to stick to funds with average portfolio maturity of say 2-3 years, even for a long-term portfolio.
While longer average portfolio maturities may deliver when rates fall, they also tend to be more volatile. Hence if you are not an active market watcher, a fund with a good combination of various instruments with the maturity specified above should help generate optimal returns.
If you are holding for the short term then liquid or ultra short-term funds would reduce this risk for you.
Credit risk
The risk arising from the credit quality or credit worthiness of the debt instruments in a portfolio is called credit risk. In other words, it is the risk that a company may not meet its debt obligations. An instrument with high credit rating (AAA, A1+ or P+) or one backed by sovereign guarantee may not face much credit risk, while lower rated instruments may have a slightly higher risk.
You might wonder why debt funds should then go for lower rated securities at all? They might as well hold all top-rated instruments and government securities. Just as equity funds buy outside the index and take exposure to some mid and small-cap stocks, so do debt funds hold instruments with varying credit profiles to earn that extra bit of return.
A fund invested in say a AA paper may benefit if that instrument is upgraded, resulting in a price rally as demand for that instrument goes up.
Managing credit risk
Most fund managers would restrict their exposure to lower rates instruments to ensure that any adverse credit quality does not hurt the portfolio. Many of these lower-rated instruments also have lower liquidity. Fund managers are therefore discreet when they choose such instruments.
However, some funds have a strategy of earning returns by going for such mis-priced opportunities. Hence you should first read the fund’s offer document to know if the fund intends to use this as its key strategy.
Also, take a look at the fund’s portfolio to know the average rating of its holding and what proportion of holding is in AA-rated or lower-rated securities. If a majority of the holding is AA or below then the portfolio is not low on credit risk. You may go for those with higher credit risk only if you have enhanced risk appetite.
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Hello Vidya,
Firstly, I really appreciate your efforts to educate the retail investors about the various nuances of the financial markets. As a formal professional equity options trader at a Wall Street Bank, I have seen this industry closely and I hate to say, but it is full of dishonest people trying to mislead retail investors for their own benefit. At a time when both our industry as well our country is losing its credibility on the global arena, it’s so refreshing to see a group of professionals willing to share their experience and provide unbiased advice without any ulterior motives. It would be really great to learn about the Indian financial markets from you, use analogies to the US market in which I was trained and in the process become a better investor.
Looking forward to learn from your blogs and the discussion that follows.
Thanks,
Yash
Hello Yash,
thanks! We also hope to benefit from your participation.
Vidya
Hello Vidya,
Firstly, I really appreciate your efforts to educate the retail investors about the various nuances of the financial markets. As a formal professional equity options trader at a Wall Street Bank, I have seen this industry closely and I hate to say, but it is full of dishonest people trying to mislead retail investors for their own benefit. At a time when both our industry as well our country is losing its credibility on the global arena, it’s so refreshing to see a group of professionals willing to share their experience and provide unbiased advice without any ulterior motives. It would be really great to learn about the Indian financial markets from you, use analogies to the US market in which I was trained and in the process become a better investor.
Looking forward to learn from your blogs and the discussion that follows.
Thanks,
Yash
Hello Yash,
thanks! We also hope to benefit from your participation.
Vidya
Could you please advise on my below query.
I `m a long term investor and having an investment in Kotak Gilt Investment Plan since Nov 2012. Now my funds sitting with -6% returns.
What should i do now.
Hello Sreejith, gilt funds are not ideal options for retail investors as they require tactical calls. having entered, I suggest you wait for some time for yields to settle. It could be November-December. Post that exit and move to an income fund. thanks.
I have invested in Long term income funds last year. They are about to complete one year wherein the exit load would be nil. Should I exit and invest in ultra short term funds? My holding period is about a year or two.
Or do u think FMP’s make a better option since repo rates are about to go up?
Hello Navin, Long-term debt funds should be held for the time frame for which they are meant for if you need to get decent returns.
Pl. ensure you are not sitting on losses in long-term debt funds. if you are, and the funds are otherwise good funds, consider holding for the time frame you mentioned. Only if the fund is non-performing and you need to exit for that reason should you look in to entering ultra short term funds.
Any fresh money at this stage can also be deployed in ultra short-term funds.
thanks
Thanks for your advise.
The funds I have subscribed for are SBI Dynamic Bond, SBI Long Term Income, Reliance Dynamic Bond. They all seem to be good funds. So even though I am sitting on losses with them,I still will continue with them for a year or two.
But what about the highly marketed FMP’s. Could u also convey your thoughts on them? Can fresh money be put in FMP’s?
Hello Naveen, FMPs up to 1 year time frame will offer good rates for some more time. You may avoid locking into longer term FMPs and instead go for income funds with shorter maturities. thanks.
Dear Madam,
I invested Rs30000/- in UTI Short term Income fund on 10th July 2013 .Now its value is only Rs.30500/-.What is your opinion about Short term funds .It will improve or its value will go down.
hello Sajith, Short-term debt funds are ideally suited for the current market condition. The said fund though has a higher portfolio maturity than peers and also higher exposure to less than AAA-rated instruments thus making it a little more risky and enhancing its volatility. thanks
Thank you madem
Dear Madam,
I invested Rs30000/- in UTI Short term Income fund on 10th July 2013 .Now its value is only Rs.30500/-.What is your opinion about Short term funds .It will improve or its value will go down.
hello Sajith, Short-term debt funds are ideally suited for the current market condition. The said fund though has a higher portfolio maturity than peers and also higher exposure to less than AAA-rated instruments thus making it a little more risky and enhancing its volatility. thanks
Thank you madem
Could you please advise on my below query.
I `m a long term investor and having an investment in Kotak Gilt Investment Plan since Nov 2012. Now my funds sitting with -6% returns.
What should i do now.
Hello Sreejith, gilt funds are not ideal options for retail investors as they require tactical calls. having entered, I suggest you wait for some time for yields to settle. It could be November-December. Post that exit and move to an income fund. thanks.
I have invested in Long term income funds last year. They are about to complete one year wherein the exit load would be nil. Should I exit and invest in ultra short term funds? My holding period is about a year or two.
Or do u think FMP’s make a better option since repo rates are about to go up?
Hello Navin, Long-term debt funds should be held for the time frame for which they are meant for if you need to get decent returns.
Pl. ensure you are not sitting on losses in long-term debt funds. if you are, and the funds are otherwise good funds, consider holding for the time frame you mentioned. Only if the fund is non-performing and you need to exit for that reason should you look in to entering ultra short term funds.
Any fresh money at this stage can also be deployed in ultra short-term funds.
thanks
Thanks for your advise.
The funds I have subscribed for are SBI Dynamic Bond, SBI Long Term Income, Reliance Dynamic Bond. They all seem to be good funds. So even though I am sitting on losses with them,I still will continue with them for a year or two.
But what about the highly marketed FMP’s. Could u also convey your thoughts on them? Can fresh money be put in FMP’s?
Hello Naveen, FMPs up to 1 year time frame will offer good rates for some more time. You may avoid locking into longer term FMPs and instead go for income funds with shorter maturities. thanks.