So, while credit downgrades and liquidity concerns had magnified the issues across the financial sector for a while now, the data certainly reflects some improvement.
Debt funds occupy approximately half of the mutual fund industry and in April, they saw cumulative inflows of Rs 1.2 lakh crore. However, retail investors have been a nervous lot, given their recent experiences with the segregated portfolio of partial investments, leading to deferral of redemption.
Given the nature of securities that debt funds invest in, debt funds are exposed to three types of risks, viz. interest rate risk, credit risk and liquidity risk.
The interest rate risk refers to changes in portfolio valuations due to interest rate movements. Interest rates and valuations of fixed income securities tend to be inversely proportionate to each other.
As such, when interest rates go south, valuation goes up, as the existing securities issued at higher interest rates can now fetch a premium in the market.
Credit risk refers to the risk of default by an issuing company. In simpler words, it relates to the risk that the company issuing the fixed income security may not be able to honour its repayment obligation in a timely manner. It is generally measured by credit rating grades, wherein AAA refers to the highest grade of the principal of safety and interest, while ‘D’ denotes that the issuer company has already defaulted on its debt obligations. As we move lower on the credit rating scale, credit risk
Liquidity risk is the risk that a fund may not be able to liquidate its investments at fair valuations, and may have to dole out higher discounts to sell the holdings on account of reduced liquidity.
Liquidity generally tends to dry up when issuer companies face credit downgrades or other adverse situations
While all of these ‘risk’ terms demand a cautious approach by investors, one needs to appreciate that mutual funds, by their very nature, go for diversification of investment portfolios. At the same time, professional fund management teams with different mutual funds are experts in their domains and select portfolio securities after due research and analysis. They use several tools to manage risks, including various derivative strategies to mitigate interest rate risks, and diversified credit profiles to manage credit and liquidity risks.
Debt funds do not rely solely on credit ratings issued by the credit rating agencies, but tend to be guided by other qualitative factors such as abnormal yields on the recent trades, concerns in group companies, etc. and generally tend to avoid such group exposures.
Debt funds also have internal exposure limits to a particular company/ group/ sector and industry, so that any rare adverse event in one company will not significantly impact the overall portfolio.
Debt funds have been helping investors diversify thinking beyond the traditional fixed income products. Don’t let the recent issues fade your trust in these funds; they know the art of managing their risks. After all, it’s all about mitigating the inherent risks