Thread by @FinsenseG

Thread: Risks with Debt Funds.

Since we have been on a bumpy road since last couple of years due to default by some of the big NBFCs. Investors seem to have lost confidence in debt funds which so-called offered a fixed return on principal amount and safety of capital.

Ignoring risks associated with these has proven fatal for investors.

What are these risks?

1) Default Risk: The risk that company may not repay the interest and principal amount due to its business failure or fraud or anything. If this happens, the schemes will see fall in NAV

2) Interest Rate Risk: This is a big one! Most of the instruments held by debt mutual funds are traded on bond market just like shares. Their prices too fluctuate. Now since this is an instrument which pays fixed interest along with principal on maturity.

Why should it's price fluctuate? Shouldn't it always trade at Face Value?

Market Price of a bond and interest rates have inverse relationship. Meaning, If the interest rates in the economy go up, the prices of bonds go down and vice versa.

Really? How?

Suppose a debt scheme has RBI Treasury Bill which was bought at Rs. 1000 and pays 8% interest per annum and is going to mature in a 3 years. So you get Rs. 80 per annum in interest.
Now RBI announces the rate hike by 50 basis points. That means the market rate is now 8.5%.

So if you make a fresh investment of Rs. 1000 in same instrument, you will be earning 8.5% i.e. Rs. 85 per annum. Now, the price of the earlier instrument held by you should fall enough to yield 8.5% on the price.

How much should it fall? It's simple to calculate that:

PV = Present value of amount earned at future date. (Suppose you are going to receive Rs. 80 at the end of 1 year. How much is it worth today if the interest rate is 10% - Rs. 72.72 (80/1.1))
Discount Rate = It is the market rate or in other words : Opportunity cost.

As you can see, The bond price & value falls when interest rate goes up.

What if interest rates go down? What will happen to value of bond?

You guessed it right! It will go up.
Check out:

3) Sensitivity: This is related to the maturity profile of portfolio of bonds held by a debt scheme.
Average Maturity is the weighted average of all the current maturities of the debt securities held in the fund. The weights are the % holding of each security in the portfolio.

If the Average Maturity of Debt Fund - A is greater than Debt Fund - B. Then Debt Fund - A is more sensitive to the interest rate changes than Debt Fund - B, meaning when the interest rate falls, the NAV of Fund - A will rise faster than Fund - B and Vice Versa.

Conclusion:
1) Ratings of bonds in portfolio is very important. This will save you from Credit Risk issues like Franklin. However ratings are not a guarantee of safety.
2) Rising interest rates will have negative impact on NAV and Falling interest rates will have positive impact.

3) Scheme with higher average maturity is more sensitive to interest rate changes than one with lower average maturity.

Tip: The above info is available in MF Factsheets. Please take a look at those before investing or consult your financial advisor.

By @RJGyanchandani