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Investing in debt mutual funds? Beware of these risks

debt mutual funds, risk,investor, IL&FS, debt, Credit risk,Interest rate risk

In debt space it is imperative that due care and diligence is applied before zeroing in on the schemes. What applies to one investor may not apply to other. Debt is that category where return potential limited and risk potential also plays a vital role, just like in Equity market.

Risks associated with debt funds are:

1. Credit Risk/Default Risk: Fund Managers take this risk to get higher returns by investing in lower quality papers, like AA, A+, etc. Credit risk is the chance that a bond issuer will not make the coupon payments or principal repayment to its bondholders. In other words, it is the chance the issuer will default. Higher this chance, higher will be the yield/return on the paper. Judicial prudence have to be applied before taking this call. Recent events have brought this risk to fore front. IL&FS, Essel Group, Jindal Gorup, DHFL, etc.. ares some of the cases where downgrade and default happened and investors had to bear the burnt.

2. Liquidity Risk: This is a risk that an investor might not be able to sell his or her corporate bonds quickly due to a thin market with few buyers and sellers for the bond. Lower quality paper have lesser liquidity and vise -Verse. During distress times in bond market liquidity dries up and not many buyers are available as a result selling of bonds becomes difficult and it has impact of returns.

3. Interest rate risk: Fall / rise in interest rates have inverse impact on the NAV of debt schemes. Debt Schemes with longer maturity papers have higher impact of fall in interest rates and vice-verse. Such risk can be mitigated by investing in shorter maturity papers.

4. Reinvestment Risk: This is another risk where once investment in a paper is matured and it has to be invested again in some other paper at lower / higher yield paper. Sometimes bonds are issued with call option, where issuer have the option to premature the bonds. In such scenario investors are left with no other option but to sit on cash or invest at prevailing market options,which could be good or bad.

5. Scheme mismatch: Another important aspect is investors requirement and selection of Schemes. This is where most of the investors falter and make wrong selection. Selection should be as per his / her requirement or investment horizon. Right from overnight to liquid to ultra short term to long duration or Dynamic funds, each category have different time horizons depending on its portfolio constitution and have different return potentials. Investment keeping in mind this aspect is equally important. Mismatch in this would leave a severe dent in investors return in case of distress in market, like that of current market conditions.

For debt schemes, safety should also precede everything else. For novice, new or retails investors high quality papers should be chosen and suggested. Credit Risk or relevant schemes should form a part of tactical allocation and that too with proper understanding of clients profile and risk. Proper understanding of these risks and its impact is important before suggesting debt to investors. Retail investors are still not aware about these risks and still consider debt funds to be risk free. This misconception in itself is very risky and needs prior attention.

There is no scientific way to select tomorrow s best funds today but one can review mutual fund schemes at regular intervals on the basis of above parameters.

(By Pritam Deuskar, Fund Manager, Bonanza Portfolio)