Like equity and hybrid funds, debt funds are not risk-free products. Neither can debt funds give assured returns. However, the debt fund risk is different in nature compared to the risks in equity funds. You should be aware of the risks in debt investment so that you can make informed investment decisions based on your financial needs. There are two kinds of risks in debt funds:-

Interest rate risk

Bond prices have an inverse relationship to interest rate changes. Bond prices go up when interest rates go down and vice versa. Interest rates can change for a variety of reasons e.g. RBI increasing interest rates to lower inflation, reducing interest rates to spur economic growth, Government borrowing more to meet fiscal deficit, appreciation or depreciation in INR versus USD or other major currencies etc.

Bonds durations are directly related to interest rate risk. Bonds of longer durations are more sensitive to interest rate changes compared to bonds of shorter durations. For example, if interest rate rises by 1%, then the price of a 7 year duration bond will fall much more than 1 year duration bond. The opposite is true, when interest rates fall; the price of longer duration bond will rise faster than a shorter duration bond. In other words, scheme duration is related to how volatile the scheme is.

At the same time, you should understand that the usual shape of yield curve is upward sloping. Bonds of longer maturity or durations give higher yields than bonds of shorter duration. This is the risk return trade-off. You should evaluate the risk return trade-off and make informed investment decisions. Interest rates move in cycles, periods of high rates will be followed by low rates and the cycle will continue. If you have invested in a longer duration fund and have a long investment tenure which spans both rising and falling rate cycles, then higher returns in period of falling interest rate will compensate for lower returns in rising interest rate period. However, if you have short investment tenure then you should invest in shorter duration funds, which are less volatile. You should select the appropriate scheme according to your investment tenure and risk appetite.

Credit risk

Credit risk is the risk of non-payment of interest and / or principal by the issuer (borrower). Credit rating agencies assign ratings to different debt and money market instruments. Lower rated papers give higher yields than higher rated papers. However, in case of rating changes, the valuation of the bond or money market instrument. If a bond gets downgraded, then its valuation will fall and vice versa. As per SEBI’s regulations, change in valuation of a bond in case of credit rating downgrade or default, needs to be reflected in the scheme’s NAV irrespective of when the bond matures.

It should be clarified that a lower rated bond may not necessarily default, but the risk of downgrade or default is higher in lower rated papers. While interest rate risk is temporary if you have long investment tenures (refer to the previous section), credit risk can be permanent. If a bond defaults in principal payment, you may not get your entire money back. Therefore, you should always be prudent about credit risk and make informed investment decisions after duly understating debt investing risk factor.