Though investing in mutual funds are beneficial but still, it carries various types of risk. This risk includes credit risk, interest rate risk, inflation risk, reinvestment risk but credit risk and interest rate risk should be considered before investing in debt mutual funds. These risks are-
1) Credit Risk(Default risk)
The risk which involves chances that borrowers might not repay the debt on the promised date is termed as credit risk. This credit risk is measured by “Credit Ratings”. There are few credit rating companies like CRISIL, ICRA, CARE, etc. whose work is to rate the issuer of the bonds on the ability to repay by assessing their overall financial health.
Illustration: Ratings & the yield
The expectation on return goes up when the credit risk increases. The credit risk of the portfolio is the most important thing to check when a specific debt fund claims to generate high returns.
The investor should know that the credit rating can change over a period of time. The overall performance and risk should be measured at regular intervals or periodicals. The risk of downgrading in the credit rating of the paper is more to be worried about than the risk of default. The portfolio is directly affected by the downgrading of the market price of such an instrument which only happens when debt paper gets downgraded. On the other hand, if the credit rate gets upgraded the fund would be benefited by an increase in its fund value.
2. Credit Spread
A credit spread can be defined as a yield difference between two bonds of similar maturity but different credit quality. A credit spread can also refer to an options strategy where a high premium option is written and a low premium option is bought on the same underlying security.
4. Interest Rate Risk
The market price of the bond and the interest rates are the opposite. When the interest rate goes up, the market price of the bond goes down and when the interest rate declines, the market price shoots up.
Let’s take an example – A bond in the market has a face value of Rs 100/- offers an 8% coupon rate with the leftover the maturity of 3 years. The interest for the next 3 years would be Rs 8/- and Rs 100/- would be the principal amount which has to be repaid at the end of 3rd year. The interest rate prevailing in the market for that bond is 9%. So, if the bondholder decided to sell his bod in the market he has to sell at discount on face value i.e. Rs 97.74/ not at the actual face value. So, the conclusion is when the interest rate rises in the market, the market price declines.
Measuring interest-rate risk – “Modified Duration”:
The work of the Modified Duration is to measure the level of changes in the price of the bond due to changes in the interest rate. The change in the price level of bond/debt can be calculated by multiplying with the change in interest with modification duration.
Weighted Average Maturity of the portfolio
One should be able to make out by looking at the weighted average maturity of the portfolio that whether it is short, medium, or long-term debt papers. How to calculate weighted average maturity? Supposedly, the portfolio of a debt fund consists of instruments with 3 yrs, 5 yrs, 7 yrs, and 10 yrs to maturity, to arrive at average maturity, add these four numbers (3+5+7+10 = 25) and divide the same by four. So the average maturity of the portfolio would be 6.25 years. This may not be the right way of communicating maturity because the investments in each of these papers may not be equal.
If different maturities and weights are given, the first step is to multiply the percentage of holding/allocation of each security with years to maturity. The total of all the weighted maturities would lead us to the Weighted Average Maturity of the portfolio.
The duration and weighted average maturity will be higher when the term papers of the portfolio are longer, hence, high volatility. Similarly, the duration and weighted average maturity will be lower when the term papers of the portfolio are shorter, hence, low volatility.
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