How to Manage Debt Funds Risk in Investment Portfolio

But they said Debt funds are Risk-Free, Aren’t Debt Mutual funds the safe investment options? This question always crops up when there is a discussion on the Risks associated with Debt Mutual funds.

Seasoned Investors in debt funds have recently experienced 2 Major Risks.

In 2017, they saw the Interest rate Risk when interest rates started moving up unexpectedly which pushed down the NAVs of all the debt funds, and since 2018, till today they are experiencing the Credit Risk, which came to fore after the Default of IL&FS Securities.

Now the question arises, if debt funds are also risky, should you go for it at all. And If yes, how to manage the Risks associated with them.

The Answer to the first question is a Big YES.

Debt mutual funds hold an important place in one’s portfolio. These are meant to provide necessary stability in the investment. In fact, debt is a very important asset class which along with stability also has potential to sometimes generate good returns, and with the tax efficiency it comes up with, it provides the necessary support to the Growth towards goals.

The second question is a bit tricky which requires you to be a bit careful and watchful while selecting the Mutual fund schemes.

SEBI has already recategorized the Mutual funds and now understanding the structure of the funds is not very difficult. But the issue lies in this simple structure itself.

There is still a room to play with the structure of the fund to generate Alpha, which makes it difficult to take the call on Funds’ selection. (Read: Type of Debt Funds in India) 

For e.g. Corporate Bond funds are mandated to have 80% of their Portfolio exposure in AA and above securities, but what about the remaining 20%, this is where Fund Managers may take exposure to low rated papers to generate some extra return.

Same way duration funds are categorized on the basis of the modified duration of the portfolio, but there is no condition on the quality of papers they are required to have. I have seen Short to medium duration funds having high credit risk papers.

Post IL&FS fiasco which has raised the question on Rating Agencies, Fund Management due diligence, the advice, in general, is coming up to avoid investing in any Duration Funds and keep yourself to Liquid and Ultra Short-term funds. As these are considered to be the Least risky segment in debt mutual funds.

Least Risky from both aspects like Interest Rate Risk and Credit Risk. As these funds keep themselves in the very low duration segment and thus gets least impacted by the Interest rate volatility, and due to the restrictions, these funds can’t go into illiquid and corporate bond papers. (Read: How to use Liquid funds to your Advantage?)

But does that mean that even the long-term investments should go into these funds to maintain the safety aspect?

In the Hindsight, if you go with the Current market voice and look at the near to medium term returns then the answer would be Yes.

But I think rather than staying away this is an opportunity to learn more on what has happened and make informed decisions.

Manage Debt funds Risk

Start with yourself. Define what you want in term of goals, and finalize the Suitable Asset Allocation.

Now before jumping to Debt Mutual funds, first look at the other alternative options available like for long term investment PPF, Sukanya Samriddhi are good being these are Tax efficient options.

(Read More: All you want to know about PPF )

(Read More: All you want to know about Sukanya Samriddhi Account )

And for the short term, you may also look for Bank FDs if the investment amount is Less. Mutual funds are no doubt tax-efficient products, but this applies to those who come under high tax bracket and have taxable Interest income.

Please do remember to get those tax efficient returns you are taking some Risk.

Yes, I agree that even bank FDs are also not Risk-FREE but still, India is not in a position to see the banks going Bust. So, my view is that small investor having the least risk tolerance should not try Debt Mutual funds.

Now when you know yourself, your tax profile, your risk tolerance, this is the time to understand the Debt Mutual funds.

Go with Ultrashort to Short term category if you still are not sure, what fund would be suitable for your requirement.

If you stay invested for the very long term, I have seen debt funds generating the same kind of returns, and there is very less difference in short- or long-term funds’ returns.

But still, Medium to long term funds may make sense only when you are having a view on the Interest rate cycle of the economy and are following an Asset Allocation approach.

debt funds risk
Source: FE Analytics, 28.05.2019. CLICK TO ENLARGE

Longer the duration of the fund, more sensitive that fund would be to interest rate volatility and also the fund may take exposure to low rated papers, and both have their own portion of risks. (Read: How to select debt funds in volatile interest scenario?)

Asset Allocation lets you do timely rebalancing. If you can do this then there are chances you may get some better returns than staying Put, though for that you need to follow a Process-oriented approach.

Conclusion:

Whenever there is a question of High or Better Returns, you are asking for some Risk along with. No return comes safely.

The basic purpose of the Debt funds is meant to provide stability in the portfolio and provide necessary push when equity markets are not doing well. But that does not mean that debt funds are not risky.

They have their own share of risks, though different from Equity markets.

Diversification among different segments of debts – Fixed income Accrual, Duration, short term, and medium term may get you the desired risk and Returns balance, but for long term investments Asset Allocation has an important role to play.

If you know the risks well you would be in a better position to manage it well.

Stay aware, stay safe, follow a Process, keep growing.

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