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Are debt funds totally safe?

Are debt funds totally safe? Or do they carry some risk? Click on the link below to read my article in Mid-day Gujarati today.

http://epaper.gujaratimidday.com//epaperpdf/gmd/11072016/11072016-md-gm-13.pdf

The English translation is as under:

Debt mutual funds – are they totally safe?

Is there a mutual fund option for someone, who does not want to take any risks? Well, there are many investors that keep asking this question. Very often, they also think that only equity funds are risky and that there is no risk in debt funds. Since debt funds invest in debt securities, these funds are exposed to the risks associated with such securities.

Today we will discuss a very important risk related to debt securities and other fixed income investments. In the language of investments, this risk is known as the default risk or credit risk. This risk is strongly associated with debt securities and other fixed income investment options.

As we understand, when someone invests in a debt security, i.e. a debenture or a bond or a similar instrument, e.g. a fixed deposit, one is lending money to someone in need of it. In case of debentures, bonds and fixed deposits, the borrower would generally be a company, a bank or a Government.

The borrower is required to pay interest to the lender, i.e. the investor. This interest is the income for the investor. This interest payable is agreed upon right in the beginning, along with the time schedule of the payment.

However, there is a possibility that the borrower may not return the money in time. This possibility is known as the default or credit risk. Such a risk is inherent whenever the borrower is anyone other than the government of the investor’s country. The risk, simply stated, is the possibility that the borrower does not pay up the dues as per the agreed schedule. The key phrase here is “as per the agreed schedule”, which means both non-payment and delayed payment are covered.

There are two factors leading to this risk – the ability and the willingness of the borrower. While willingness is difficult to measure, the ability can be measured through the financial statements, especially in case of a company. This is done by the credit rating agencies and they assign credit rating to the various debt papers issued by the borrowers for the purpose of lending. Please remember, the rating is assigned to a paper and not to the issuer.

Between short term and long term borrowing, one may consider the long term borrowing to be riskier as the uncertainties rise with the increase in the term of borrowing. Similarly, if the borrowing amount is small, the ability is higher than if the same is large. Companies may also issue debentures backed by the security of asset. Such secured debentures may enjoy higher rating than an unsecured paper issued by the same issuer.

Though credit rating could be a good starting point to evaluate whether to invest in certain debt papers, the risk does not completely go away even with the highly rated papers. The risk keeps rising with the drop in credit rating. A proven and time-tested method to reduce such risk is to diversify across various issuers. The ability to repay is less likely to suddenly drop across different companies operating in different businesses and industries.

This risk is present in all debt securities, as already mentioned earlier. The only issuer that is considered to be free of this risk is the government of a country, since it is authorized to print currency in case the need arises. For any other entity, the risk is higher than zero.

Debt mutual funds invest in debentures, which carry this credit risk. Hence, the debt fund investors are also exposed to this risk, indirectly. If a debenture in which a debt fund has invested defaults, i.e. does not return the money in time, the NAV of the debt fund would drop to that extent.

However, there are two major reasons that reduce this risk for debt funds:

1.     A professional fund management team evaluated which securities to invest in. being a professional, the fund manager is likely to do a better job than most individual investors.

2.     By regulation, the debt fund portfolio needs to be diversified across issuers. As we discussed earlier, diversification also reduced the risk of default.

Apart from that, an investor can evaluate which schemes to invest in based on (1) the investment objective as defined in the offer document and (2) the portfolio as disclosed in the monthly fact sheet of the fund.

A very important piece of information in the fact sheet is the rating profile of the fund, which shows how much is the scheme’s exposure in what type of credit rating. If the investor is uncomfortable with high exposure in lower rated papers, one may avoid the scheme altogether.

Debt funds, though not risk free, are a great way to invest for the conservative investor, as the risk of default is managed through professional fund management and diversification.

-        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.

Questions regarding mutual funds - answered during the chat session today on www.moneycontrol.com

Click on the link below to read the transcript of my chat today on Moneycontrol.

http://www.moneycontrol.com/news/mgmtinterviews/chats/detail_new.php?chatid=2667

Chat transcript on www.mooneycontrol.com date: 9th May, 2016

Equity investments simplified

You must know this about MF SIP returns

Many investors look at point to point returns offered by the scheme and try to judge SIP returns offered by the scheme. This can be way off mark.

Read more at: http://www.moneycontrol.com/news/mf-experts/you-must-know-this-about-mf-sip-returns_6586141.html?utm_source=ref_article

Live online chat on mutual funds today at 4 PM

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Questions about mutual fund investments

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Questions on mutual funds, answered

Investors had queries on investing and mutual funds. Here is the link to the transcript of the chat:

Build wealth with mutual funds

Are mutual funds really transparent?

“Why do you say that mutual funds are transparent? I don’t agree.” Someone asked. ... 

Read on ...

http://epaper.gujaratimidday.com//epaperpdf/gmd/05102015/05102015-md-gm-14.pdf


The English translation of the article is as under:

“Why do you say that mutual funds are transparent? I don’t agree.” Someone asked.

“Well, why do you say so?”

“You know when I buy stocks, I know exactly what price I would get, but when I buy mutual fund units, I do not know at what NAV I will get the units. Where is the transparency?”

Good question. Someone buying something would like to know the price at which the purchase happens. If you only get to know it later, there has to be a very strong reason for the same. Still the investment vehicle that claims to be transparent, does not allow one to know the transaction price in advance.

Let us understand the reason for the same. (The discussion refers to transaction prices in case of open-ended mutual funds only).

First of all, pricing. Mutual fund units are priced once a day for declaration of NAV. So, for all open-ended mutual fund schemes, there is only one transaction price per day. This price is linked to the NAV for the day. This NAV factors the closing prices of all the securities at the end of the day, which are available after the day is over.

While the transaction is reported before a cut-off time, the NAV is calculated hours after the cut-off time. Thus, it is impossible for one to know the NAV at the time of the transaction. The only known price (or the NAV) is that of yesterday.

Why should one not be offered the previous day’s price? That brings us to the second reason, which is the principle of fairness. As we have seen earlier, a mutual fund is a collective investment scheme. There are a large number of investors participating in such a scheme. In an open-ended mutual fund scheme, on any business day, there could be some investors entering, some exiting and some others doing no transaction at all. All the investors must get a fair price and none of these should be able to profit at the cost to others.

All the security prices as of previous day have been factored in calculation of the NAV as of the previous day. Today’s prices are yet to be known.

If someone were to be offered units at yesterday’s price for a transaction done today, the one-day gin (or loss) would go to someone buying today, without even putting any money. In that case, the income investor is likely to watch the prices and do a transaction only if it is beneficial for him (or her). The loser would be the investor who has stayed invested for long.

Thus, the question is not so much about transparency, but about how the NAV is calculated and offering fair prices to all investors.

-        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.