Beware of these risks while investing in debt mutual funds

Credit Risk

Default in payment of principal amount by the bond issuer results in credit risk. You can find out which bond has higher credit risk and which bond has lower credit risk by looking at its rating by the credit rating agencies. The higher credit rating of a bond shows low risk. Usually government securities have a high credit rating in comparison to the corporate bonds.

A debt mutual fund usually invests the corpus in a diversified portfolio of securities. You must check the credit rating of the securities in the portfolio before investing in a debt mutual fund.

If a credit rating agency lowers a particular bond's rating to reflect more risk, the bond's yield will increase and its price drop. While investing a debt mutual fund, it is always wise to check the quality of its portfolio investment and the credit rating of such investments. Always invest in a fund with stable portfolio and a highly proficient AMC.

Interest Rate

Interest rate has significant impact on the debt mutual fund’s return. Whether you invest for a short term or a long-term perspective if there is fluctuation in the prevailing interest rate, then return on your debt fund will be impacted accordingly. Interest rate and the price of a bond are negatively correlated.

It means if the interest rate revises upward, then the price of the bond will go downward and vice-a-versa. This happens because when the interest rate falls, then the price of the bonds in which debt mutual funds invest, it goes up, therefore the value of such mutual fund increases as well. Similarly, when the interest rate goes up, then the bond value goes down and simultaneously the debt mutual fund value also falls.

So, when investing in the debt mutual fund you must assess the interest rate situation correctly or the investors can choose to invest in dynamic bond funds. In dynamic bond funds, the fund manager can change the allocation based on his view on interest rates and economic scenarios. But, the investors have to be prepared for a loss, if a fund manager commits a mistake and predicts the interest rate movement wrongly. Suppose, you invested in a long-term debt fund while anticipating that the interest rate will fall, expecting rise in NAV of the debt mutual fund. However, the interest rate starts moving upward and bond prices falls steeply resulting in a drop in the NAV of the debt mutual fund which has large exposure in such bonds.

So, while investing in the debt mutual fund always keep track of interest rate trend and if the interest rate is expected to move upward, then better to avoid the long-term debt fund and invest in the short-term debt fund to avoid losses.

Other Risk

Other risks such as inflation risk, liquidity risk, market risk, etc. are also associated with the debt mutual fund investment.

Inflation risk may hurt you in two ways. First, inflation may result in surge in interest rates, therefore the fund value may go down. Secondly, you may find the inflation rate to be higher than the return on the debt fund i.e. your investment corpus will get a negative real rate of return.

Liquidity risk refers to how easy you can move in and exit the fund whenever you want.

When you invest in a debt mutual fund, then it is important to select the appropriate fund based on your financial goal because it may not be productive to quickly exit the fund. First, figure out your investment horizon and then choose a fund matching your profile. Be careful about the scheme specific risks and the credit risks of the fund. Be mindful about the changing interest rate environment which will have a big impact on debt mutual funds. Take help of the expert investment advisor in making the right selection of fund.

(The writer is CEO, BankBazaar.com)