Take note of risks in debt funds

With a view to safeguard the interests of investors in debt funds, SEBI recently tightened the norms for debt funds’ exposure to corporate bonds.

These regulations are a result of the sharp fall in value of two JP Morgan debt funds last year which had high exposure to bonds of Amtek Auto that were suspended/downgraded by rating agencies.

Recently, a rating downgrade by CRISIL saw the value of holdings on Jindal Steel & Power dip.

Most of us are unaware of the risks around debt funds, which invest in instruments such as government bonds, corporate bonds and other money market and short-term debt instruments.

Here’s what you need to know before investing in debt funds.

Bond prices can fall too

Just as the NAV (net asset value) of your equity funds can fall along with the underlying stock prices, so can the value of your debt fund with underlying bond prices.

Bond prices reflect the ability of the company to service its interest or principal and hence, rise or fall based on the financial performance of the company. Interest rate movements, too, can impact bond prices.

If interest rates move up, bond prices fall. This is because investors flock to newer bonds that offer higher rates.

This reduces the attractiveness of older bonds and hence their prices decline.

The reverse holds true under a falling rate scenario when bond prices move up.

Hence, before investing in debt funds, you need to take note of such risks that impact bond prices.

High concentration risk

Debt funds that invest predominantly in corporate bonds face the risk of default, particularly from lower rated ones.

Often, investors go for funds that can earn higher interest by investing in lower rated bonds (non-AAA rated).

For instance, the yield on the 10-year government bonds (viewed as risk free) is currently at 7.8 per cent. AAA rated corporate bonds deliver 8.6 per cent return. Lower rated AA or A currently earn 9.1 per cent and 10.8 per cent return, respectively.

Thus, debt funds that invest more in lower rated bonds can capitalise on such interest receipts. These funds tend to outperform other debt funds in a lacklustre market. In 2015, for instance, while gilt funds that mainly invest in government bonds delivered 5-6 per cent returns, debt funds investing in corporate bond funds (with more exposure to lower rated bonds) managed to rake in higher returns — nearly 2 percentage points more.

While you may be tempted to invest in such debt funds to earn higher returns, there are a few checks you need to run before doing so. If the fund’s holdings are skewed more towards bonds rated below AAA, its risk is pegged higher. This is because the credit risk in such bonds is higher.

If a company actually defaults on its interest or principal repayment, then the debt fund’s portfolio, to that extent, is written off.

This will impact the NAV of the debt fund. Even if a bond does not default, rating agencies can downgrade the rating on these bonds owing to several reasons. This can also mark down the value of the fund’s NAV. This is what had triggered the sharp fall in two of JP Morgan’s debt funds, one of which had about 15 per cent exposure to Amtek Auto’s bonds that were downgraded by rating agencies.

To mitigate some of these risks, SEBI recently pruned the exposure limit a debt fund can have to one issuer, from 15 per cent to 10 per cent of the NAV. This may be extended to 12 per cent of NAV with the prior approval of the Board of Trustees and the Board of the Asset Management Company.

Too many eggs in one sector

Just as in the case of equity funds, sectoral exposures can also have a bearing on the risk quotient of debt funds. Given the current risks in certain sectors such as banking, infrastructure or power, debt funds having higher exposure to bonds issued by companies in such sectors carry higher risk.

Hence, do look at the sector exposure in debt funds before investing. A diversified portfolio with minimal exposure to stressed sectors may bring down the risk.

SEBI has now reduced exposure to a single sector from the current 30 per cent to 25 per cent and reduced additional exposure provided for HFCs (housing finance companies) from 10 per cent to 5 per cent. Investments in bank certificate of deposits, government securities, treasury bills, short-term deposits of scheduled commercial banks and AAA rated securities issued by public financial institutions and public sector banks are excluded from such limits.

SEBI has also capped a debt fund’s exposure to a group — entity with its subsidiaries and associates — to 20 per cent of NAV. This excludes investments in securities issued by public sector units, public financial institutions and public sector banks.

Rates matter too

So why take risk in debt funds that invest in corporate bonds at all? If you thought you could avoid risks by investing only in debt funds that have a portfolio of risk-free government bonds, think again.

As mentioned earlier, rate movements can also impact bond prices. Hence, longer duration bonds are more sensitive to interest rates. Even if you choose to invest in gilt funds you need to watch for risk from rate movements. In a rising rate environment, it may be wiser to stay away from funds with longer duration bonds.