Understanding risk of debt funds vis a vis equity funds

Debt Mutual Funds mainly invest in a mix of debt or fixed income securities such as Treasury Bills, Government Securities, Corporate Bonds, Money Market instruments and other debt securities of different time horizons. Generally, debt securities have a fixed maturity date & pay a fixed rate of interest.

Understanding risk of debt funds vis a vis equity funds

Why are debt fund returns easier to predict than equity fund returns? (Debt funds invest in Bonds which have a fixed coupon and the cash flow from this is predictable subject to two risks – interest rate risk and credit risk). It has to do with risks of these two types of investments. Debt fund investments risks are subject to two variables – interest rate and credit quality changes (and issuer concentration from a fund portfolio perspective). Equity fund investments risks are subject to many variables like market risk, sentiment (both global and domestic investors), sector valuation changes relative to other sectors, company performance on a year on year and sequential basis, company performance relative to sector, sectoral composition of the fund, company concentration of the fund etc. Let us compare these different risks.

Interest Rate Risk

In terms of controllability, interest rate risk in a debt fund can be compared to the market risk in an equity fund, because the fund manager does not have any control over these risks. Now ask yourself, how much Sensex or Nifty can fall in a year? In bad years, we have seen Sensex or Nifty fall by 20% to as much 50%. Next ask yourself, how much can interest rate rise in a particular year (bond prices fall when interest rate rises)? In terms of magnitude, interest rate risk cannot simply be compared to equity market risk.

Further more, while market risk affects all equity funds to a certain degree, effect of interest rate changes on different debt funds are very different. Very short duration debt funds, like liquid funds and ultra-short term debt funds are not affected by interest rate changes in the short term. Short duration accrual based debt funds like short term debt funds or even some corporate bond funds are little affected by interest rate changes.

Long duration debt funds, on the other hand, can be impacted significantly by interest rate changes. Longer the duration of a debt fund (e.g. long term debt funds, income funds, long term gilt funds etc.), higher is the interest rate risk. You can find the duration of a debt fund scheme in the factsheet. If you want to avoid interest rate risk, simply select low duration debt funds with high yield to maturity. You should ensure that, the duration of the fund matches with your investment horizon. However, if you select a low duration debt fund, profits from interest rate declines will be limited. If you select a long duration debt funds, you can get high returns when interest rates fall. You should understand the risk return trade-off and make a decision based on your investment objectives. You should also know that, over a sufficiently long investment horizon, interest rate risk is low (because long investment tenures will have periods of both rising and falling rates). Your investment decision should also be informed by your investment horizon.

Credit Risk

Let us now come to credit risk. For the purpose of comparison with equity fund, you can compare this risk with company performance (earnings). If a company’s earnings (profit after tax) fall,the market is likely to punish it in terms of stock price, unless the market was expecting the earnings to fall. However, a small fall in company’s earnings may have no effect on its debt servicing capacity and hence its credit rating can remain unchanged; consequently, no impact on bond prices. Hence the natures of these two risks are quite different.

Higher the credit quality of a bond, lower is the risk of credit rating downgrade or default, e.g. the risk of an AA rated bond defaulting is much less than a BB rated bond. Therefore, if you want to reduce the credit risk of your investment select a debt fund which has a high proportion of AA or higher rated bonds in its portfolio.

However, you should note that, lower rated bonds give higher yields. Not all lower rated bonds get downgraded; only a few ones facing serious financial troubles are downgraded. If you want to capture an extra few percentages of yield you can invest in credit opportunities funds, but as always, you should be cognizant of the risks. We must caution investors that, sometimes even a relatively highly rated debt paper (bond) can suddenly be downgraded. This will impact the returns of funds holding a high percentage of such papers in their portfolios. There have been a few instances like these in the past two years or so.You should be mindful of the risk of an unexpected rating downgrade.