While mutual funds can help manage credit risk and reinvestment risks, investors must understand how individual mutual fund schemes function before committing their hard earned money
Income fund, also known as debt fund, invests in a basket of fixed income securities such as bonds, debentures & money market instruments like certificate of deposit, commercial paper. These schemes are devoid of equity exposure and ideally suited for risk averse investors. However, such instruments carry broadly three types of risks – credit or default risk, interest rate risk & reinvestment risk.
Credit risk arises when there is a delay or default from the issuer both in terms of timely payment of interest and principal. The degree of risk is generally denoted based on the ratings assigned by credit rating agencies. For instance, AAA denotes the highest safety, A – adequate safety & D – default. Ratings are by no means an assurance of repayment. It is an opinion representing the probabilistic estimate of the likelihood of the default and is subject to change either way.
Interest rate risk refers to change in the value of the bond price due to increase or decrease in the level of the interest rate. The sensitivity depends on the maturity of the underlying. Longer the maturity, higher the fluctuation of the bond price and vice versa. Reinvestment risk is more prevalent in a declining interest rate scenario. That is the risk of future coupons/interest from a bond not getting reinvested at the rate when the bond was initially purchased.
Is this all sounding scary? The objective is to help you understand some of the nuances and take an informed investment decision. How do you manage these risks or should you just hire experts – mutual funds, to do it for you? While there are too many variants in the debt category, we shall now focus on two solutions - short term bond funds and long duration fund. The investment objective and the risk return trade off are distinctly different for these two mutual fund options. Short term fund is intended for investors seeking stable income accompanied by low volatility with an investment horizon of two years and above. Generally, such schemes have a portfolio maturity of around 2- 2.5 years and relatively less sensitive to interest rate movements. On the contrary, long duration fund is a tactical play on the interest rate scenario. Typically, investors with high risk appetite get into such products in a potentially favorable interest rate scenario i.e. when the interest rates are expected to soften. Portfolio of such schemes would have long duration bonds and government securities demonstrating higher degree of sensitivity with an average maturity of around 7 – 9 years. Ability to time the entry and exit becomes the key to investing in long duration funds.
Unlike equity, investors in debt scheme look up for regular fixed returns. Is debt funds substitute to fixed deposits? Not really! For a moment assuming the credit risk being equal, debt mutual funds do not offer fixed/assured return. Why is this? An open ended scheme attracts regular flows at varying points in time exposing it to ‘interest rate risk’ potentially impacting the return of the portfolio. But, the taxation aspect overrides the shortcoming compared to fixed deposits. Units held in debt schemes for a period of 3 years and above attract long term capital gain tax which is currently at 20%, making it a strong case for investors in the higher tax bracket.
Investors looking for certainty in returns may consider fixed maturity plan. How does it work? For instance, if the prevailing yield of one year debt instruments are around 9% and the expense ratio is 0.50%, the indicative return would be 8.50%. Such plans are available in varying tenor’s right from 90 days to 3 years. You may choose the most appropriate one or a combination of plans based on your cash flow requirements. Being a close ended scheme, one can subscribe during the new fund offer period only and suited for those willing to lock in their money for a fixed tenor. Generally such products enjoy higher appeal in a rising interest scenario. Since the maturity date of the underlying debt investments and the maturity of the scheme fall on the same date, interest rate risk is eliminated to a larger extent. Unlike open ended schemes, the fund house does not extend re-purchase facility in the interim taking away the liquidity advantage. Although the unit of the scheme gets listed on the stock exchanges for the purpose of liquidity, there are hardly trades. Even if random trade happens, it is usually at a discount to the NAV. Investors should put in their money that they do not require till the maturity of the scheme. Also, one does not have access to the portfolio before investing. Hence investors have to exercise utmost diligence before making an investment decision.