In our previous article we learnt about debt fund, stating debt funds are mutual funds, which invest in debt market securities. Debt funds are suitable for investors who are looking for investment with minimal chances of losing money. With lesser risk, the return associated with it is also smaller.
Spotlight to be on the word lesser... There is no investment with zero risk apart from fixed deposit. Even fixed deposit has risk of being taxed at higher rate, if there are any changes made by government are put into place.
Debt fund is also prone to some risk, associated with the debt market securities. Some risk can be dealt with diversification called unsystematic risk, other one being market risk, systematic risk which one can’t get away with.
To begin with...
The first and foremost risk associated with debt is default by the company or government. Debt is simply giving money to any individual for a specific period of time to earn interest. And on a specific date, the debtor has to return money to the lender. If on that date, debtor (in this case company or the government) failed to pay the money back that is what credit risk is.
Credit risk also decides the prices of the bond, higher the credit lesser the price of the bond, because no one will be willing to pay to any individual or any one institution and vice versa. Credit rating agencies like, FITCH, CRISIL, GOLDMAN SACH, MOODY’S, S&P to name few; give ratings to the economies and institutions as well. US bond has the highest ratings, as the world feels it’s the most reliable bond, with almost negligible credit risk. This rating is very obvious, as US dollar is compared to Gold, which is considered as Safe Haven investment, in case of any turmoil on the earth.
Why do we give debt to any one, or lend money to anyone??
If we go and ask any money lender, his major interest is the “interest” he earns from the principal and not the principal. Principal is his secondary interest. Other Risk which is associated with the debt is company or the institution failing to pay coupon on specific time.
Credit risk and interest are connected to each other. Higher the credit risk, higher will be the interest rate associated with the bond. As interest rate is the compensation for blocking the money, in that case, higher the risk, higher the compensation required for taking the risk associated for lending the money to an institution.
However these two risks can be dealt with by diversifying investment by putting money into some other investment asset class, having lowest correlation with bonds.
Now comes the market risk.. These are risk, which can’t be diversified. Systematic risk affects the overall economy and the market.
Prevailing interest rate in the banking scenario does play a major role in the debt market. Interest rate is inversely related to the pricing of the bond securities, thus affecting the debt funds. However, the movement of interest rate affects differently to different bond. Rise in interest rate have positive effect on the bonds with shorter maturity, but an adverse effect on the bond with longer maturity. Duration of the bond decides how an interest will play on bonds.
Now comes the liquidity risk,
Debt fund does have chances to face liquidity risk. Liquidity risk basically refers to the problem faced by the an investor or fund manger to sell bonds or debt securities, if there is very low demand or no demand for the bond or debt securities, which he/she wishes to sell. No such problem persists in equity fund or equity market amid higher demand most of it higher awareness.
So, an investor must always do his/her homework before investing, to reduce the chances of losing out money in the market.
That is why it is said,
“Investments are subject to market risk, read the documents carefully, before investing.”