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At present you should stick to funds that avoid both duration risk and credit risk?

Debt funds are sold to investors as a less risky alternative to equity funds. However, investors should not make the mistake of equating these funds with instruments like fixed deposits where there is no risk of loss of capital. In debt funds, investors can suffer erosion of their capital, owing to a variety of risks.

The first type of risk in debt funds is interest-rate risk. When interest rates are falling, prices of bonds rise. This results in capital gains within mutual fund portfolios, which boosts their returns. But when interest rates are rising, prices of bonds within debt fund portfolios decline. Such losses are higher in case of bonds of longer tenure, and lower in bonds of shorter tenure. Over the past year and a half, interest rates have been on the upswing in India. In such a scenario, investors should stick to debt funds that have a low average maturity. Liquid funds, ultrashort term debt funds, and short-term funds are some of the categories of debt funds that investors should stick to in a rising interest rate environment.

The second type of risk that debt funds face is credit risk. When a bond that is held within a mutual fund portfolio gets downgraded, or defaults, the net asset value (NAV)of the fund declines. This is what has happened in the case of IL&FS and its group companies. This company and its subsidiaries currently have a total debt burden of around Rs. 90,000 crore. Of this mutual funds hold around Rs 2,282 crore. In recent times, IL&FS and its group companies have either delayed payments or defaulted on payments of various papers. NAVs of many funds have got eroded due to these events. When investing in debt funds, investors should select funds that largely hold AAA-rated bonds.

Another issue in India is that credit rating agencies are not one step ahead of evnts. As the IL&FS and several other incidents in the past have demonstrated, credit rating agencies tend to downgrade the ratings of bonds under their watch after a payments delay or default has already happened. In the case of a medium-duration fund or a credit risk fund, where investors usually invest with a three-year horizon, there is a high probability that the fund will recover from the loss in case of a default. But when a shorter duration funds suffers a default, there is no time to recover from the loss.

IL&FS and other similar events demonstrate that fund managers cannot just depend on the ratings provided by rating agencies. They also have to do their own due diligence. In the case of shorter duration bonds (like commercial papers) they need to keep a close eye on the cash flows of the company, instead of just going by the paper’s rating.

Investors need to stick to fund houses that have established research teams on the debt side that can do proper credit monitoring. Also make sure that exposure to a single company or group does not exceed 2.5-3 per cent of the fund’s portfolio. If the fund manager is well diversified, the loss due to a downgrade or default will be limited.

Currently a category of funds exists called credit risk funds. These funds invest a larger proportion of their portfolio in papers having lower credit quality. Fund managers take higher risk in these funds to earn extra returns. Investors should confine their investments in these funds to barely 10-20 per cent of their total debt fund portfolio.

When you take risk in equity funds, you are compensated by commensurately high returns. In the case of debt funds, you should adopt a policy of safety first. In the current environment, it is best to have a larger proportion of your debt fund portfolio in funds that do not take either high duration or credit risk.