Taking a bet on debt funds: The risks you should know of as an investor

Losing investments is if companies default on their debt obligations

Debt funds were not perceived to be as risky as equity funds. But as recent episodes of sudden downgrades have shown, debt investments are risky, and it is possible for investors to lose their capital if companies default on their debt obligations. The turmoil in the past few months perhaps is a wake-up call for investors who prioritise returns over safety and liquidity.  Here is a look at the key categories and the risks associated with them:

Liquid funds

These funds invest in debt and money market securities with maturity of up to 91 days. These funds are among the safest within debt categories because of the short duration, but do come with an element of credit risk.

For instance, on September 10, net asset values (NAVs) of a few liquid funds fell by 1 per cent after the debt papers issued by Infrastructure Leasing & Fina­ncial Services were downgraded by rating agencies. However, instances when liquid funds see such a large drop in NAVs are rare.

Short- and medium-duration funds

These schemes invest in debt and money market instruments of duration between one and four years. These schemes come with an element of duration as well as credit risks. “There are categories where it is not expressly stated but fund houses have the leeway to take credit risk. All of these categories (such as short and medium duration) do not have any specific measure of what their credit risk should be. As a result, unless the fund house has a very clear stated strategy, it is possible that fund houses do take credit risks off and on to get the extra bit of yield in such funds,” said Vidya Bala, head–mutual fund research, FundsIndia.com.

Credit risk funds

These funds invest a minimum of 65 per cent of their assets in papers rated ‘AA’ or below. Such funds take a deliberate credit risk and seek to gain from mispriced opportunities or gain from higher accrual in corporate bonds that do not enjoy high credit rating.

One-year returns of the category are 3.4 per cent, the second-lowest among debt categories, according to Value Research.

Such funds can benefit if the economy is expected to improve and the ratio of upgrades to downgrades increases. According to experts, such funds are only suitable for high networth and savvy investors. One of the factors to look at before investing is the lumpiness of the portfolio. If two fund houses have 40 per cent of their portfolio in A-rated papers, invest in one whose portfolio is spread across 20-30 papers rather than one invested in 10 papers.

Long duration, dynamic bond, and gilt funds

These are longer tenure funds with portfolio durations typically exceeding seven years. They come with an interest rate risk since they primarily rely on duration play. These funds are often volatile with periods of negative returns and investors may have to stay invested for longer periods for the interest rate cycle to play out. Three successive rate cuts in the past few months and expectations of further softening in the coming months have augmented the returns of such funds.

Fixed maturity plans (FMPs)

While FMPs can help investors circumvent interest-rate risk, they are susceptible to credit risk. This is especially pertinent in the current environment, when a number of corporates are facing the risk of defaults and downgrades. The risk level is higher in FMPs because of their close-ended nature, which means that all the securities mature on the same day. “We generally do not recommend FMPs to investors as you cannot exit the investment even after you become aware of the risk,” said Bala.