Risk management for debt funds
Risk management should come first and investment should come next while building your portfolio. It is akin to going for a dual, where you should first learn how to defend yourself so that you remain in the game for long. Once you have mastered the art of defence, you can then go for offence. Your aim should be to defend yourself so that you can play longer and win. The risk associated with an investment in equity is well understood but many investors have a wrong perception that debt funds are safe. Since the IL&FS default in September 2018, we have seen many incidences that have shaken our belief about the risk of investing debt funds. The latest case of shutting down six of its debt-oriented funds by Franklin Templeton has further highlighted the importance of risk management even in debt funds. Following are the risks associated while investing in debt MF schemes:
Credit risk or default risk: This is a risk wherein chances are that a borrower might not repay the interest or principal on the amount taken. Credit risk is measured by ‘credit ratings’ given by various credit agencies to the issuer of the debt. The higher the credit rating, the lower the chances of default or credit risk.
Interest rate risk: Bond prices are inversely related to the interest rate; as the interest rate increases, bond prices decline, and vice-e-versa. The interest rate risk is measured by a modified duration that evaluates the price sensitivity of the bond for a given change in interest rate. By multiplying the change in interest with the modified duration, the change in the price of the bond/debt fund can be calculated.
Liquidity risk: The winding-up of six debt mutual fund schemes of Franklin Templeton India was due to the liquidity issue of the fund. Sometimes, the fund may not be able to sell the underlying holdings due to a lack of a buyer. In this case, the fund house will not be able to give back the money and this is called the liquidity risk. Liquidity is very much connected to the credit rating of the securities. A fund with sovereign and AAA-rated securities will have higher liquidity and can be sold off easily and quickly without much impact cost.