which are recommended for conservative investors,
are also not free from risks. The investment portfolio of these funds comprises
fixed income instruments, which make periodic payouts and repay the principal
amount at maturity. The value of the fixed income instruments is influenced by
changes in economic indicators, such as short-term and long-term interest
rates, inflation, government deficits and balance of payments. Let us consider
some of the risks faced by the manager of a debt fund.
Credit risk: This is
also known as the default risk and arises from the possibility that the issuer
of the debt instrument may be unable to pay periodic interest or repay
principal on maturity. The credit worthiness of the issuer is assessed through
the ratings assigned by credit rating agencies. Generally, the lower the credit
rating, the higher the credit risk, and vice versa. A fall in credit rating
leads to a drop in the price of the debt instrument and this significantly
impacts the fund's NAV.
Interest rate risk:The
price of debt securities, especially bonds, is extremely sensitive to the
movement in interest rates. The price of a bond falls as the interest rate
rises, and vice versa. Therefore, the value of bond investments is adversely
affected during a period of rising interest rates.
Consider that a substantial corpus of a fund is invested in a
10% coupon bond, which is purchased by the fund manager at its face value of Rs
1,000. Its price will go down to Rs 833.33 if the general level of interest
rate goes up to 12%. Accordingly, this negatively affects the value of the
fund.
Reinvestmentrisk:The
varying interest rate levels in the economy give rise to such a risk. It refers
to the probability that the periodic cash flow from bonds will be reinvested at a
rate that is less than the coupon rate of the bond. This reduces the cumulative interest component of
the bond, which, in turn, reduces the value of the fund. Consider a fund, which
has invested in a 10% coupon bond that pays a half yearly interest.
The purchase price is Rs 10,000 and its term is five years. If
periodic interest payments are re-invested at the coupon rate, the cumulative
interest component after five years will be Rs 6,254. However, if the interest
rate falls to 8% after three months (and remains constant thereafter), the
cumulative interest component will plunge to Rs 5,981. This deficiency in the
value of the cumulative cash flow reduces the fund's value as well as its NAV.
Marketability risk:The
secondary market for debt is not fully developed in India. The transactions in
the debt market are usually concentrated in very few securities. Moreover, the
trading volume varies for different securities on a daily basis. These market
characteristics expose the debt mutual funds to marketability risk. While
transacting in debt securities, funds are exposed to a substantial impact cost
(measured using bid price and offer price), which impacts the value of a fund
significantly.
For minimising some of the market risks, such as interest rates
and currency movements, fund managers use derivative markets for hedging their
positions. Derivatives are highly specialised instruments and offer
opportunities with disproportionate gains. However, they are also associated
with disproportionate losses. While these securities offer strategies for
reducing losses in the equity and debt markets, they are themselves not free
from risks
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