Not always risk-free
Debt funds.
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Debt funds are not without their share of risks, although of a lower degree
than equity. Interest rate risk is the biggest they face.
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Vidya Bala
Did you recently hear somebody say "Debt funds are safe; your capital and
returns are assured"? Well, you should probably discount such a statement.
While the current equity market rout has led many to seek cover in debt
options, it is important for investors to know that debt options, especially
debt funds, are not without their share of risks, although of a lower degree
than equity.
This article seeks to highlight one of the prominent risks faced by debt mutual
funds - interest rate risk.
NAV fluctuations
Debt funds are often perceived as providing fixed return as they invest in
instruments that typically have a set coupon/interest rate.
This is, however, a mistaken belief, for the simple reason that the NAV of a
fund is not derived from just the income from the instrument; the NAV also
fluctuates based on the market price of the debt security.
But why should the price fluctuate? Prices of debt instruments move in response
to market perception of interest rate movements. Debt funds are therefore
subject to interest rate risks.
Let us take the case of corporate bonds, one of the most common instruments in
which a debt fund invests.
Suppose a debt fund invests in a bond issued by company X that has a coupon
rate of 10 per cent on a face value of Rs 100.
When the market interest rate moves up to 11 per cent, company X cannot
increase the rate, nor is it obliged to, as the coupon rate is already set.
In order to realign the Bond X's yield to market rates (11 per cent), the bond
price has to fall to Rs 90.9. In other words, in a rising interest rate
scenario, bond prices fall, if their coupon rate is lower than market interest
rate or the perceived interest rate.
Similarly, in a softening interest rate situation, when the bond's coupon rate
is higher than the market rate, bond prices rally to realign or bring down the
yield to market levels.
Thus, when bond prices rally (on softening interest rates), the NAV of the debt
fund holding such instruments too rise and vice-versa. In other words, the
price of a debt instrument has an inverse relationship with interest rates.
Portfolio maturity
How does a debt fund manage this risk? Tweaking the fund's portfolio maturity
(average maturity period of instruments in the portfolio) is one of the key
tools.
Suppose a fund manager anticipates a fall in interest rates in the market, he
may choose to increase exposure to instruments with longer-term maturity. This
provides scope for the bond prices to rally over a longer period, until it
realigns with the falling market rates.
However, what if the actual rate cuts are lower than what the market
anticipated?
In such cases too, the longer-dated instruments, that had rallied believing
that there will be high rate cuts, run the risk of losing value to retain the
market yields.
Thus in uncertain times/rallying rate regimes, a typical flexi-debt fund may
prefer to retain a lower portfolio maturity.
Clear evidence of falling interest rates may prompt fund managers to increase
portfolio maturity
http://www.thehindubusinessline.com/iw/2008/12/14/stories/2008121450471000.htm
Government cannot make man richer, but it can make him poorer
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