Whether you want to invest in equity or debt - please consider the risks involved. Understand the risks and manage these. Here is my article in Mid-day Gujarati explaining the risk involved in debt securities and debt funds:
The English translation is as under:
The English translation is as under:
Last time, we discussed about one of the risks involved in debt securities and hence in debt funds. This time around, we would discuss another of the risks that exists, but majority of the retail investors are not aware of it.
In the debt market terminology, this risk is know as “interest rate risk”. In order to understand this risk, let us take the example of a debenture issued by a company.
This debenture was issued for a period of 5 years or the maturity of the debenture at the time of issue was 5 years. Two years have passed since and hence the debenture would now mature in 3 years.
Assume that this debenture is rated AAA – highest safety
Its face value is Rs. 100 and it bears coupon of 9% p.a. payable annually. This means the debenture holders would be paid Rs. 9 (9% of the face value of Rs. 100) every year for each debenture they hold.
Now assume that for some reason the interest rates in the economy come down – we have seen this happening in case of bank fixed deposits or recently in case of small savings or PPF – by 1% p.a..
This means, similar debentures (AAA rated debentures with a maturity of 3 years) would be available in the market offering a yield of 8% p.a.
Now when other debentures offer 8% p.a. and our original debenture, which was issued earlier is offering 9% p.a. That makes it more attractive compared to other debentures in the market.
Due to this attractiveness, investors would want to buy this debenture (We have assumed that such a debenture is traded in the stock market). This buying interest results in the rise in the market price of this debenture. The market price of such a debenture would rise to such an extent that now the return on investment in this debenture would fall to 8% p.a. Calculations indicate that the market price should rise to Rs. 102.58 per debenture.
This means that when you invest Rs. 102.58 in a debenture; earn interest income of Rs. 9 per year and get a maturity value of Rs. 100; the return on investment would be approximately 8% p.a.
On the other hand, had the interest rates gone up in the market to, say 10% p.a., our debenture’s market price would have fallen to Rs. 97.51.
As can be seen from the above example, the market price of an existing debenture falls when the interest rates in the economy go up. At the same time, a drop in the interest rates in the economy results in rise in the market price of existing debentures. Thus, there is an inverse relationship between the market price of existing debentures and the interest rates in the economy.
Now, assume the same company had issued another debenture at the same time, but for a maturity period of ten years. Hence, when two years passed from the issue of both these debentures, the two debentures would have a residual maturity of 3 years and 8 years, respectively.
If the interest rates fall by 1% p.a., one debenture offers higher interest for 3 years, whereas the other offers higher rate for 8 years. Thus, the relative attractiveness of the second debenture would be even higher and hence, the market price of the same would rise much more than the first one.
This is another fact that one should remember in case of debentures. Debentures with longer maturity witness bigger price changes when interest rates in the economy change.
The investors, who hold the debentures till maturity, do not have to worry about these changes in the market prices. They are unaffected by such changes. However, if someone needs to sell the debentures in the market before maturity, such an investor would be concerned with changes in the market prices – especially if the interest rates rise, causing the market price of the debentures to fall. At the same time, if the same investor continues to hold the debenture maturity, one would get the maturity value, as this is the contracted value.
While the debenture holders may hold the debentures till maturity to avoid the interest rate risk, debt mutual funds cannot. As we have seen earlier, the investors in (open-ended) mutual funds are allowed to transact at NAV linked price on all business days, the calculation of fair price must happen on a daily basis. For this purpose the NAV calculated on a daily basis must value all the debentures at the prevailing market price. Hence, an investor investing in a debt fund may witness frequent changes in the NAV of the fund. Having said that, such an investor would be better off holding the fund units for a recommended holding period in order to reduce the impact of interest rate risk.
A debt fund investor can also decide how much interest rate risk one wants to take. As we saw some time ago, debentures with longer maturity are more sensitive to changes in interest rates compared to those with shorter maturities. An investor can check the average maturity of a debt fund and decide to invest in one with low average maturity in order to avoid interest rate risk. An aggressive or a savvy investor, willing to take the interest rate risk may choose a debt fund with long average maturity. The details of a fund’s average maturity may be seen from the fund’s fact sheet.
Understand the risk in debt funds and take an informed investment decision.
- Amit Trivedi
The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.