Do you know how to select debt funds: understanding the risk

Over the past few months, I have come across a number of senior citizens, relatives, parents of friends, acquaintances etc., in weddings and other social occasions; their concerns were with falling interest rates of fixed deposits and small savings schemes, on which they depend for their regular post retirement income. A number of these people told me that they are very interested in exploring debt mutual funds. Some of these seniors citizens had many years of experience, investing in equity mutual funds, but as far as debt funds were concerned their perception was that, these funds were risky, difficult to understand and difficult to match with investment objectives.

As far as the perception that debt funds are risky is concerned, this is due to risk attitudes of many investors who perceive risk to be a binary characteristic – either risky or risk free. So, while these investors appreciate the fact that equity is risky, they expect other asset classes to be risk free. What they fail to appreciate is the fact that, there are different grades of risk (often linked with investment horizon). While debt funds, unlike fixed deposits and small savings schemes, are subject to market risk, their risks are much lower than that of equity funds. Further, different types of debt funds have different risk grades.

Debt funds are much more predictable than equity funds

As far as the perception that debt funds are difficult to match with investment goals is concerned, I have the exact opposite view. I think that, it is much simpler to match debt funds with investment goals compared to equity funds. Let me explain. There are different types of equity funds based on market capitalization strategy of stock selections, e.g. large cap funds, multi-cap funds, mid and small cap funds etc., each with its own risk / return characteristic. How do I know, which fund is suitable for my investment goal, other than subjective notions with regards to my risk appetite? Further, there are funds based on different investment styles like growth, value, growth at a reasonable price (GARP) etc. How do I know, which investment style is better suited to my investment goals? What I am trying to say is that, there is a considerable amount of subjectivity involved in choosing the right type of equity fund for a specific investment goal.

On the other hand, I can be highly objective in choosing the right type of debt funds for specific investment objectives. This is because fixed income investment is more mathematical (analytical) compared to equity investment. Let me explain with a help of an example..

Let us assume that a debt fund has a Yield to Maturity of 8%, Modified Duration of 3 years and high credit quality. Regular readers of our blog may be familiar with concepts like Yield to Maturity and Modified Duration, but if you are not, do not despair; we will explain these concepts soon. If the interest rate changes by 0.5% (up or down) in the next 12 months, then we can with a fair bit of confidence that the return will be in the range of 6.5% to 9.5% (ignoring expense ratios for the sake of simplicity). Readers should note that, there was no expert judgement involved in our estimation of debt fund returns; it is driven by bond mathematics, which we will explain later. Moving on equities, can anyone say, with any reasonable degree of confidence, how much return will a multi-cap equity fund give in the next 12 months? The answer, very likely, is no.

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.

Conclusion

In this series of posts, we will try to demystify debt funds with the objective of making you a smarter debt fund investor. Once you have a clear grasp of how these funds work, you will not find debt funds too confusing and complex to match with your own investment objectives. In this blog post, we have discussed the types of risks of debt funds and also compared the risk between debt and equity funds. In the next post, we will discuss various types of debt funds and understand how it can be suitable for your investment needs.