Debt mutual funds explained: Key risks and how to manage them

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Debt mutual funds invest funds in fixed income instruments like government securities, corporate bonds, and money market instruments. They are less risky than equity funds since they invest in assets paying interest, but safety is relative. They are less volatile, but with inherent risks that affect returns if not managed correctly.

Interest rate risk

The biggest risk in debt funds is interest rate movement. When interest rates rise, bond prices fall, and consequently the net asset value (NAV) of the fund falls. Falling rates rise returns. Debt funds with a long duration are most vulnerable to this kind of risk because small interest rate moves can make a large difference in returns.

Credit risk

Credit risk is when issuers of the bonds default on payment or get downgraded. When a fund invests in lower-rated securities to generate higher returns, the chances of such defaults occurring are greater. The Franklin Templeton debt fund crisis in 2020 revealed how one-sided bets on riskier securities can punish investors when redemptions go through the roof and liquidity dries up.

Liquidity risk

The debt funds may struggle to shed the underlying securities in periods of market stress, instigating liquidity risk. In the event that most investors withdraw simultaneously, the fund manager may be forced to sell off the bonds at a loss, reducing the value for the rest of the investors. This risk is greater for the funds with exposure to low-rated corporate debt.

Managing risks as an investor

Investors must manage risks by equating their choice of debt funds to their time horizon of investment. For short-term needs, ultra-short duration or liquid funds are suitable, while long-term investors can choose dynamic bond funds. One must ensure the quality of the fund's portfolio, holding credit ratings, and diversification. Adhering to funds that have an investment in largely government securities or high-rated corporate bonds can reduce credit risk.

Being disciplined in debt fund investments

Debt funds are a fine diversification instrument and reasonably stable returns, but with careful selection and monitoring. Avoid chasing the highest returns, as they have higher risks. Instead, seek out stability, portfolio clarity, and goal congruence. Consulting a financial advisor before making any allocations will provide the optimal balance between safety and returns.

FAQs

Are debt mutual funds absolutely risk-free?

No. Even debt funds are less risky than equity funds, but they are not risk-free. They carry interest rate risk, credit risk, and liquidity risk, which affect returns. Investors should not think that they invest in fixed returns similar to bank FDs.

What is the safest debt mutual fund for short-term schemes?

For short-term needs, ultra-short duration funds and liquid funds would be safer. They invest in high-quality, low-maturity instruments and are less interest-sensitive.

Can debt mutual funds provide negative returns?

Yes, under certain situations. If interest rates rise unexpectedly, or the fund contains securities with defaults or downgrades, NAV may fall and induce short-term losses. The risk is less probable, however, in government bond or AAA-rated portfolios.