Last Updated on September 27, 2023 at 3:51 pm
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.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! 🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
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
This does not hold any govt bonds. The (weighted) average maturity is currently 4.77 years (VR).
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).
Corporate 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!
You Can Be Rich Too
My new book with PV Subramanyam, published by CNBC TV 18
The book comes with 9 online calculator modules to create your own financial plan.
It also has detailed selection guides for equity and debt mutual funds.
Amazon (₹ 347)
Kindle (₹ 244.30)
Infibeam ₹ 280 with Coupon BS10
Googe Play Books App Store (₹ 244.30)
What Readers Say
- This is perfect book on personal finance. Very nicely explained about taxation about debt mutual fund. Topics like early investing and asset allocation are very well explained. – Mahesh Deshmukh
- Highly Recommended For anyone who wishes to take control of his/her finance this book is a must read. Very simply put, even an amateur in finance will be able to understand and implement. The author genuinely attempts to inculcate the habit of investing among the people who have the ability to invest but refrain from doing it, either due to lack of time , interest or understanding!. The message from the book is ” Investment done without setting a goal/ objective is like leaving for a trip without knowing the destination, not everytime the end result will be promising. Hence, it’s important to invest in a planned & disciplined manner.” A read is highly recommended ????
- A must book for everyone who wants to take control of personal finance. Nice explanation of how a debt mutual fund works. Bonds trading and indexation benefits in high inflation years were something new I learnt. After reading this book you will be able to easily choose any funds, because you will know what that fund does or how that fund works
Read all reviews here: Amazon Customer
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)