Understanding Risks in Debt Mutual Funds: A Simplified Guide for New Investors

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Debt mutual funds might seem riskier compared to fixed deposits (FDs), don’t they?

It’s true—they come with risks like credit risk, interest rate risk, and liquidity risk. For new investors, these financial jargons can be confusing and daunting. But let’s simplify this by telling a straightforward debt story that you can easily relate to in your daily life. Ready to dive in?

Are Debt Mutual Funds Risk-Free?

It’s a common misconception that debt mutual funds are risk-free. While they are indeed among the least risky types of mutual funds, they are not entirely without risk. Why is this? Because, like all mutual funds, debt funds are market-linked products.

This means that while they generally offer more stability compared to equity funds, they are still influenced by market conditions. Factors such as interest rate changes, credit risks, and liquidity issues can impact their performance.

So, can you really expect a debt fund to be completely risk-free? The answer is no. Understanding the inherent risks, even in supposedly safer investments, helps you manage your portfolio more effectively and make well-informed decisions.

1. Understanding Default Risk

Imagine there are three friends in a city named A, B, and C. One day, A and B were sitting in A’s house, chatting over a cup of tea. During their discussion, B asked A if he could lend him some money, as B was planning to expand his business.

Since they were good friends, A agreed to give him a loan after a week. They both settled on the following terms:

A will lend B an amount of 1 Lakh for a duration of 1 year.
The interest charged would be 10% per annum.
B will pay a monthly installment of 1,000 per month (interest amount). At the end of 1 year, B will return the principal amount of 1 Lakh to A.

The First Thought: What If?

Now, if you were in A’s position, what would be the first thing that comes to your mind? Naturally, the first thought that came to A’s mind was, “What if B is unable to return the 1 Lakh after a year or fails to pay the interest?”

I’m pretty sure this would be your first thought too if you were lending money to a friend. This concern leads us to an important concept in finance.

What is Default Risk?

This is called Default Risk. Default Risk occurs when a borrower is unable to return the interest and principal amount. There can be various reasons for defaulting on a payment.

For instance, consider the recent COVID-19 pandemic, where numerous businesses were forced to shut down, leading to many defaults.

Understanding these risks is crucial when navigating the world of debt mutual funds and other investments. By grasping these concepts, you can make more informed and confident financial decisions.

2. Understanding Credit Risk

Assume everything is going well in B’s business. Then, one unfortunate day, a social media influencer writes a scathing review about B’s business. The negative words spread like wildfire, leading to a sudden decline in B’s business.

This bad news also reaches his suppliers, who used to provide raw materials on credit. Alarmed by the downturn, they stop extending credit. Overnight, the creditworthiness of B’s business plummets. What is this risk called?

What is Credit Risk?

This is known as Credit Risk. Credit Risk occurs when the creditworthiness of a business declines. A recent example of this is the case of DHFL, where the company’s rating was drastically downgraded, and it struggled to meet its debt obligations.

Credit Risk in Debt Mutual Funds

In the realm of debt mutual funds, understanding credit risk is crucial. Often, it is credit risk that leads to default risk. However, it’s important to note that a company’s rating downgrade doesn’t necessarily mean it will default on its obligations.

Being aware of these risks helps you navigate the complexities of debt mutual funds and make more informed investment decisions.

3. Understanding Interest Rate Risk

Now, imagine a third scenario where everything is going smoothly. B is paying the interest on time, and A is confident that B will repay the principal amount as agreed.

Then, A’s other friend, C, approaches him and asks for a loan of 1 Lakh for business expansion, offering an interest rate of 15% per annum. This puts A in a dilemma.

He starts wondering if he made a mistake by lending 1 Lakh to B at an interest rate of 10%. This situation brings to light a risk A never anticipated. What is this risk called?

What is Interest Rate Risk?

This is called Interest Rate Risk. Interest Rate Risk occurs when you have already given a loan at a specific interest rate, but due to changing economic conditions, the prevailing interest rates are higher.

You are then left with no choice but to accept the losses since your loan is locked in at a lower rate for a certain period.

Interest Rate Risk in Debt Funds

Interest rate risk is a critical factor in debt funds. When interest rates rise, the value of existing bonds tends to fall, as newer issues come with higher yields, making the older, lower-yielding bonds less attractive.

Conversely, if interest rates fall, the value of existing bonds can rise. Thus, interest rate risk can work both ways.

Being aware of interest rate risk helps investors understand the potential fluctuations in the value of their debt investments and make more informed decisions.

4. Understanding Liquidity Risk

Let’s move on to a fourth scenario. A has lent 1 Lakh to his friend B. After a month, A faces an emergency and needs 1 Lakh immediately. He approaches B and asks for the money back, but B is unable to return it since he has already invested it in his business expansion.

With no other options, A turns to his friend C and asks if he could lend 1 Lakh. A suggests that C could take over the agreement with B, receiving the 1 Lakh back from B after one year with monthly interest payments.

Essentially, A is proposing to transfer his agreement to C. However, C offers only 90,000 for this arrangement, stating that otherwise, he cannot lend 1 Lakh to A. What is this risk called?

What is Liquidity Risk?

This is called Liquidity Risk. Liquidity Risk arises when you are unable to sell your securities in the market when needed. Even if you manage to sell them, there’s a high chance you’ll do so at a loss due to the illiquid nature of the securities.

Liquidity Risk in Debt Funds

In the context of debt funds, liquidity risk is a significant concern. When you cannot readily convert your investments into cash without a substantial loss, it can create financial strain, especially in emergencies. Understanding this risk is crucial for managing your investment portfolio effectively.

Being aware of liquidity risk helps investors prepare for potential situations where they might need to access their funds quickly and underscores the importance of maintaining a balance between liquidity and returns in their investment strategy.

5. Understanding Asset Risk

Revisiting the first scenario where B borrowed 1 Lakh from A, let’s add a twist—A asked B for some collateral as security. B recently purchased a bike worth 1.20 Lakhs and agreed to give this bike to A as collateral.

What Happens When Collateral Falls Short?

After two months, B started defaulting on the monthly interest payments. After waiting for another two months, A decided to sell B’s bike to recover the loan.

However, when he went to the market, the resale value of the bike was only 80,000. With no other options, A sold the bike at this price. Despite having an asset as collateral, A incurred a loss of capital. What is this risk called?

What is Asset Risk?

This is called Asset Risk. Asset Risk occurs when you have the right to sell assets if the borrower defaults, but the value of the asset is insufficient to cover the outstanding loan amount. In this situation, the lender may lose both capital and the asset’s value, even after selling the collateral.

Asset Risk in Debt Investments

Understanding asset risk is crucial for both lenders and investors. Even with collateral, there’s no guarantee that the asset’s value will be sufficient to cover the loan in case of default.

This highlights the importance of thoroughly assessing the value and liquidity of collateral assets when lending money or investing in secured debt instruments.

By being aware of asset risk, you can better navigate the complexities of lending and investing, ensuring more informed and secure financial decisions.

Can Debt Mutual Funds Go Negative?

Debt mutual funds are often seen as relatively less volatile compared to equity mutual funds. But can they ever go negative? The short answer is yes, they can.

While debt mutual funds are generally more stable over the long term, there is always a possibility of negative returns in the shorter term. Why? Factors like interest rate fluctuations, credit downgrades, or liquidity issues can all impact the performance of a debt fund.

So, what should you take away from this? Even though debt mutual funds are considered safer, it’s crucial to stay informed about potential risks and market conditions.

Isn’t it better to be prepared for all scenarios rather than be caught off guard? Understanding the risks ensures you can make more balanced and confident investment decisions.

Closing Remarks

Debt mutual funds can feel intimidating compared to the safety of fixed deposits, but understanding their risks makes them more manageable. Default risk, credit risk, interest rate risk, liquidity risk, and asset risk each have their nuances. So, how do you navigate these complexities?

Remember the scenarios we discussed—lending to friends, dealing with bad reviews, facing higher interest rates, needing quick cash, and handling collateral. Each example highlights a different risk and shows why it’s essential to stay informed.

Isn’t it worth knowing these risks to make smarter investment choices? By grasping these concepts, you can confidently balance risk and return, ensuring a more secure financial future. Invest wisely, and let your journey be one of growth and stability.

Understanding Risks in Debt Mutual Funds: A Simplified Guide for New Investors

Table of Contents:

Are Debt Mutual Funds Risk-Free?