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Debt Mutual Funds: Credit Risk and Interest Rate Risk Can Co-exist!

I would like to discuss the dangers of investing in debt mutual funds without understanding risks in the next few posts. There are two problems associated with putting all eggs in one basket and we only talk about one - the basket coming apart. The second and equally important problem is the search for the new basket when we realise the old one is going to (or has) given away.

If that search is done in haste (often is) by looking only at reward, it is like taking a leap from the frying pan into the fire. So many people want to invest in debt mutual funds now. Some because they want better returns than fixed deposits due to the policy rate slide and some want to bolt the barn door after the horse has bolted - profit from falling gov bond yield.

In this post, I will focus on the former group looking for an alternative to FDs and discuss other risks in a later post.

I love debt mutual funds and have written so many posts on them that I have a separate category. Our new book, You Can Be Rich Too With Goal-Based Investing has a detailed section on understanding debt mutual funds for beginners - how to understand risks and how to choose them - fast.

It is a however, a huge subject and I have not even covered the tip of the iceberg. Hope to do that here.

There two types of risk associated with a debt fund. I have covered them in detail before:

Understanding Interest Rate Risk in Debt Mutual Funds

Understanding Credit Rating Risk in Debt Mutual Funds

With a follow-up: How to choose debt mutual funds with no credit risk and low volatility

Interest rate risk refers to how the NAV depends on actual RBI policy rate changes and the expectation of a change. When rates fall, the NAV increases becauses existing bonds in the market become valuable and vice-versa.

Credit risk refers to the perceived credit worthiness of a bond, both by the market and rating agencies. If bonds become more worthy, they become more valuable and vice-versa.

I would like to tackle a common misconception in this post: Some funds have credit risk and some funds have interest risk. That is, they do not co-exist.

Wrong!

If a debt fund holds only gilt (GOI) funds (regardless of duration), it will only be subject to interest risk  All other debt funds will be subject to both credit risk and interest rate risk.

Even corporate bonds funds, and especially corporate bond funds which holds bonds that mature in a few years will be subject to interest rate risk.

As an example, consider the NAV movement of  Birla Sun Life Corporate Bond Fund. 

This does not hold any govt bonds. The (weighted) average maturity is currently 4.77 years (VR).

corporate-bond-fund-2
Screengrab from Value Research

As you know, govt bond yields started to drop post Nov 8th due to increased liquidity in the system and hopes of a rate cut. Read more: Should I buy Long Term Gilt Mutual Funds?

Notice how the Birle Corp. bond fund reacted to this change. When the RBI kept the policy rate unchanged, the yields increased again. To understand why, see: The Rate Cut in Perspective.

In response to this, the fund's NAV dropped (faster than it rose). To reiterate, this is a corporate bond fund responding to interest expectations (and disappointments).

Many ultra-short term fund unit holders also felt these changes. However, since the average maturity of a ultra-short term fund is much lower than that of a corporate bond fund, the change would be much smaller.

Thumb rule: Higher the average maturity, higher the interest rate sensitivity (and higher the credit rating sensitivity).

Why do corporate bond react to govt bond yield changes?

Short answer: Risk premium

Read more: What is risk premium and why it is important

Not so long answer: The yield of a bond (in simple terms) is the IRR or the equivalent of annualized return (taking into account interest payments). This yield changes with the duration of the bond.

Usually long-term bonds have a higher yield than short-term bonds, but situations like voaltile exchange rates or a recession can reverse this.

When the yields are plotted agains duration it is known as a Yield Curve. The picture below shows the yield curve of govt bonds and corporate bonds (of a particular rating, say AAA).

bond-risk-premiumCorporate bond yields are higher because, they are not as credit worthy as the government. Therefore, they will have to offer a higher interest payout.

This is the premium that a corporate bond holder gets for the risk that she takes. The govt. bond yield curve responds to market forces and specific events. So imagine the green line moving up and down and changing shape.

When this happens, the red line closely follows this movement. As a result, the risk premium - the gap between the two curves changes with time.

Therefore, corporate bond mutal funds react to interest rate movements, simply because the risk premium itself is volatile. The risk premium is also known as credit spread.

Therefore: Credit Risk and Interest Rate Risk Can Co-exist!

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My new book with PV Subramanyam, published by CNBC TV 18

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