Risks involved in Debt Funds

To diversify your investment portfolio, mutual funds are considered as one of the best option as it gives an opportunity  to invest in a distinct asset class and with an expert management at the same time. The investors with the high-risk appetite can go for equity mutual funds on the other hand investors with lower risk appetite can invest in the debt funds.

Debt funds carry lower risk as compared to the equity funds, but they are not risk free. There are some risks which debt funds carry. Being a mutual fund investor, it is very important to be aware of these risks. Lets have a look at the risks involved in the debt fund investment.

Credit Risk

Credit risk arises from the default in payment of the principle amount by the bond issuer. An investor can evaluate that which bond has higher credit risk and which has lower with the help of the credit rating issued by the rating agencies. Higher rating suggests a lower risk and vice versa. Generally, government securities have higher credit rating as compared to corporate bonds. Usually a debt mutual fund scheme invests the corpus in a diversified portfolio of securities. Hence, investors should check the credit rating of the securities before investing in a particular debt mutual fund scheme.

Interest Rate

Whether an investor is investing in short-term debt funds or long-term debt funds interest rate plays significant role in determining your returns. Interest rates and price of bond move in opposite direction, that is, it posses inverse relationship. That is when the interest rate goes up, then the price of the bond goes down, so the value of such asset in the scheme decreases. Similarly, when the interest rate falls the bond value goes up, thereby the debt mutual fund value also goes up. So, while investing in the debt mutual fund schemes investor should always keep track of interest rate trend. If the interest rate is expected to move up then its better to avoid the long-term debt funds and prefer the short-term debt funds to limit losses and vice-versa.

Inflation and Liquidity Risk

Investor should be aware of inflation risk and liquidity risk. Inflation may result in rise in interest rates so the fund value may go down. Liquidity risk is how easily you can enter and exit the scheme whenever you want without much of impact cost.

While investing in a debt mutual fund scheme, it is important to select the suitable fund based on financial goal as it may not be productive to exit the fund before it serves the purpose for which it has been invested. Investors are advised to first determine their investment horizon and then select a fund. Moreover one should be careful about the scheme specific risks and the credit risks of the fund and changing interest rate environment which will have a big impact on debt mutual funds.