Understanding Risks Linked with Debt Mutual Funds

 

The growing popularity of mutual funds in India can be seen in the significant rise in the number of folios being managed by the industry, which stood at 13.56 crore as of July 31, 2022, according to the Association of Mutual Funds in India. Among the different types of mutual funds, debts funds have been attracting Indian investors due to their lower risk, compared to equity or hybrid funds. However, debt mutual funds are still exposed to some market risks, which are important to know to make an informed investment decision. There are 3 types of risks that even the top debt mutual funds could experience.

1.    Credit Rate Risks

The fund in which you invest will lend money to certain companies, banks, and even the government. The risk of the borrower failing to make the required repayments to the fund is called credit risk. Rating agencies, such as Crisil, Care and ICRA, are responsible for rating these borrowers on the basis of their record of repaying their debts. A company that has received an AAA rating from these agencies is considered to have negligible risk of defaulting on payments of interest and the principal amount.

However, private companies are considered to be higher risk, since there have been instances in history when such companies have gone bankrupt and defaulted on paying back. When you invest in debt funds, make sure you analyse the portfolio to understand how the assets will be allocated.

2.    Interest Rate Risks

The interest rate is typically dependent on the economy. If the economy is growing, interest rates paid on investments tend to rise, while if the economy is slowing down, interest rates typically fall. Also, longer maturity funds tend to have higher interest rates than smaller duration ones. The price of bonds decreases when the interest rate goes up and vice-versa. Also, interest rates may vary from one fund to another.

3.    Liquidity Risks

The top mutual funds trade their securities daily in the debt markets, just like shares. The only difference is that debt securities are traded mostly by companies, governments, banks, or other large financial institutions. In such cases, individual investors are unaware of the daily change in prices. The fund manager has to ensure that the securities have enough liquidity so that the fund can move in and out without affecting its value. Changes in economic and market conditions could reduce the liquidity of the debt securities. In such cases, the debt mutual fund will not be able to sell the securities and repay investors. This risk is termed liquidity risk.

Before you invest in the top debt mutual funds, make sure you understand the risks and debt fund returns. Remember that while debt funds are lower risk investment vehicles, risks cannot completely be eliminated in market-linked products.