Debt mutual fund & its risk – evaluate before investing

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What is debt mutual fund?

Debt mutual fund is funds that invest in fixed income security instruments. For instance, instruments like bond, T-Bills (government security), corporate bond and money market instrument. Further, such funds also invest in other debt securities for different tenure.

In general, such funds are of fixed tenure. Also, they pay fixed interest rate till maturity as decided at the time of investment. Debt funds are low-risk instruments, therefore are less volatile compared to equity funds. They expect to provide steady and low returns with respect to the equity market.

Classification of debt mutual fund based on maturity

In the market, debt funds are available for different tenure from the range of short-term, medium-term to long-term.

The short-term debt mutual fund invests in money market instruments.

A money market is a highly liquid market with a very short-term maturity. The maturity of money market instruments varies from overnight to one year. Examples of money market instruments are commercial paper, Certificates of deposits, T-bills for 91 days, 180-days, 365-days, etc. Participants of money market instruments are banks and corporates or institutional bodies.

So, short-term mutual funds are highly liquid and provide an assured return within the short period of time.

Medium-term debt mutual funds invest investor’s fund for the time horizon of between one to three years. Such funds categorized as medium-term debt mutual funds.

Long-term debt mutual funds invest investor’s fund for the tenure of more than three years.

Generally, long-term debt mutual funds debt funds invest some part of the funds in AAA rated bonds. And some part in the bonds rated lower than AAA. However, the fund house does not invest in such instruments those have the credit rating lower than AA. There is a strong reason why fund houses do not invest in the debt funds that carry credit rating lower than AAA. Actually, fund houses hope that AA-rated companies will improve and grab the higher ratings within next 2-3 years, hence it will lead price appreciation of bonds.

Now let us understand the risk associated with the debt mutual funds

The risk associated with the debt mutual funds

Basically, three types of risks are involved with any debt based mutual funds. I describe briefly each one of such risks below –

1. Impact of the interest rate on debt mutual funds

There is a negative correlation between interest rates and bond prices.

When Interest rates rise and the economy grows, bond prices fall. The reason behind this is, investors, start to withdraw their fund and invest the fund in bonds with the higher interest rate. This reaction of investors towards increasing interest rate drag down the prices of bonds.

The opposite happens in case of when interest rates fall, more investors start to invest their funds in the existing bonds. Because the interest rate or coupon they intend to receive is higher than the market interest rate hence increased demand push the bond prices up and likewise there will be capital appreciation in place.

2. Impact of maturity on bond prices

Bonds with longer maturity carry more risk of price volatility. The reason is, in the longer term there are more chances that the market interest will change and change in interest rates leads to change in bond prices. Hence, longer maturity causes the greater degree of price volatility.

3. Impact of the credit rating on bonds prices

Credit rates like AAA, AA, and BBB etc. are given to the bonds by credit rating agencies like ICRA, Crisil, and CARE. These ratings signify the degree of risk to default in the payment of principal amount and interest on investor’s investment. These ratings help investors in deciding about in which bond he/she should invest.

For example- there is the negligible possibility of defaulting in payment by the companies those have AAA rating or AA rating.

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