Risk of debt mutual funds

There is a misconception among many investors that investing in a bond or debt fund carries no risk. When compared to stock prices, bond prices are less volatile; however, it would be naive to believe that investment in bond comes with no risk. Investment in fixed income carries a risk that varies with the type of debt and the issuer. There are chances that, if you try to sell a bond before maturity (similar to the case of Franklin Templeton India), you could lose money on it due to the adverse movement in the interest rate or due to fact that the quality of the issuer has deteriorated. Similarly, you could lose your entire investment if the bond issuer goes bankrupt.   

There are different types of risks and you should be aware of how these affect your bond investments. By risk, we mean the possibility of losing the money. Some of the most important risks carried by the bonds and the debt funds are:

Interest rate risk

Suppose, you purchase a bond issued at Rs 1,000 that pays a yearly interest of seven per cent. After a few months, interest rate rises and a new issue of bonds of comparable quality and maturity is being offered for Rs 1,000 per bond that pays interest of 7.25 per cent. Investors who wish to purchase existing bonds would not pay Rs 1,000 for bonds from your issue because they can purchase similar bonds with a greater coupon rate (7.25 per cent versus 5 per cent). Consequently, when you try to sell your bonds, they would decline in price so that; they also offer a similar yield to their investors. This is interest rate risk, where the bondholder suffers a decline in its bond prices owing to the increasing interest rate. Similarly, when market rates of the interest decline, prices of the existing bonds increase. The price of fixed income security changes inversely to the changes in the interest rates.

Default or credit risk

Another risk involved while investing in bonds is the creditworthiness of the issuer of the debt. Creditworthiness is an ability of the issuer to make its scheduled interest payments and to repay the principal when the bonds mature. Credit risk varies with bond issuers. However, issuers can experience financial difficulties, which could result in their bonds being downgraded by any of the major credit rating agencies. The impacts of a downgrade in ratings result in a decline in the price of a bond issue, even though the issuer may still be able to pay its interest obligations. DHFL, Indiabulls Housing Finance, Essel are some of the examples, where we see a sharp downgrade in the ratings of the paper issued by them and hence, the loss suffered by the funds invested in them.

Liquidity risk

Liquidity risk is the risk that means a bond cannot be bought or sold without a significant price concession. Since most bonds trade over the counter, there may not be a ready buyer or seller on the other end of your trade for a bond resulting in a large price concession. Something similar happened with Franklin Templeton India recently. Consequently, thinly traded bonds, especially with a lower rating (below AAA) are highly illiquid. The bid and ask spread is generally not easily found for bonds and many brokers mark up their bonds to include a profit. Another factor that adds to the illiquidity of bonds is that the commissions or markups to buy and sell bonds in odd lots are larger when trading in round lot sizes.