Debt funds have been traditionally considered as low risk investment avenues in India. Risk-averse investors have considered debt mutual funds as a substitute to fixed deposits. However, no mutual fund is ever completely independent of risks—we can merely ‘limit’ them.
There are primarily two types of risks that are involved. One is the ‘duration risk’ that arises out of interest rate changes that affect both medium as well as long-term funds. The second is the ‘credit risk’ that in this case arises when the investor is exposed to the debt of companies who lack good credit quality.
Even if overriding a duration risk is impossible, there are ways and means in which you can limit the credit risks involved with debt funds.
The Role of Time
Time frame plays a pivotal role in the funds you choose and the associated risks they involve. If you have a time frame that is short, then you cannot afford to take duration based risks. One needs to be completely sure of getting the capital back, and in the process ensure your returns are much higher than other options—such as the interest rate offered by your savings bank account.
So in case you have a time frame of less than a year, you should simply stick to short-term and liquid funds. These help you to reduce risk as they have options that are low-risk, and even if they have commercial papers, the duration remains very short.
Avoiding Pure Credit Schemes
These days there have been numerous funds that have started the strategy of probing deeper into the credit space, for maximizing yields as well as finding short-term opportunities in corporate credit. As this is a high-risk category, you should take a call only when you are completely aware of the overall credit cycle in the corporate world.
Funds such as these often have a portfolio maturity that is low to medium, and requires a relatively longer time frame in order to get the accrual. A basic mismatch between the timeline you desire and that which the fund requires, will lead to your loss. So if you are basically using debts for asset allocation, then this is definitely not ideal for you.
Understanding Debt Funds that are Diverse
If you have time frame of two years or over, you should look for such funds that have diversified tactic. There should be a mixture of corporate bonds, gilts, and some short duration certificate of deposits and commercial papers. You can then play the duration game through gilts, and this will also give you sufficient acquaintance with corporate opportunities. You can find this sort of fund profile in income accrual and dynamic bonds categories. You should make sure that exposure to the AA-rated or the so-called lower instruments is not over 5-10%.
You should perform quarterly checks or ask you advisor so that you have a clear picture whether the fund that you have does not involve any concentrated exposures. For instance, an illiquid bond instrument that accounts for 10% of the net asset value (NAV) can prove to be harmful in case of any defaults.
Higher Return is Equivalent to Higher Risks
Funds that offer top returns are looked upon as quite tempting. The same thing happens in the case of debts. You should understand which of the funds that are providing higher returns than its peers, is actually going to fit you.
Logic states that no debt fund can have a high yield to maturity until and unless it involves higher risks, or maybe is taking bets on the market going a certain way. So a higher return potential always features a higher degree of risk. Taking the risk to simply protect your equity portfolio by involving yourself in such a fund would be unwise.