Direct & Indirect Taxes, Tax Ready Reckoner, Tax Management, Tax Act. & Rules, Tax Planning & Tax Savings.

Direct & Indirect Taxes, Tax Ready Reckoner, Tax Management, Tax Act. & Rules, Tax Planning & Tax Savings.

Risks in Debt Mutual Funds Investing

Debt mutual fund invest in fixed income security which is also known as debt securities, Debt which includes securities and investment option such as money market instruments government securities corporate bonds treasury bills and others.

The capital gain in debt Mutual Fund is been treated as short term capital gain if it is external less than 3 years and long term capital gain if the tenure is greater than 3 years and accordingly it is taxed.

For short term capital gain it is being added to the income of year of Redemption and is being taxed as per the Tax slab.

And for long term capital gain that is more than 36 months the individual has to pay 20% tax on the gains after indexation.

Indexation it means that the adjustment of capital gains with respect to current inflation rate that is removing the impact of inflation on the returns and then paying tax on the rest.

Risks in Debt Mutual Funds Investing
[Risks in Debt Mutual Funds Investing]
Cost inflation index that is CII is been used to calculate the inflation which is provided by the Income Tax Department for every year.

And formula is for calculating index investment amount

Index investment amount = (CII redemption year/CIT investment year) x Invested amount

After subtracting this indexation in investment amount from the investment amount we get the net taxable amount for the capital gain earn by Debt Mutual Fund.

And the point to be noted here is the benefit of indexation is the most important benefit which Debt Mutual Fund have over fixed deposits of bank because in fixed deposit of banks we don’t get the benefit of indexation.

And again in form of interest which is earned on the fixed deposit of bank if it is more than rupees 10000 TDS will be levied of 10% If the pan card is provided and if the pan card is not provided then 20% tax will be levied for the domestic deposit and in case of NRC deposit the TDS of 3 0.09% is applicable.

And this TDS is charged without any indexation on the entire interest income received from this fixed deposit investment of bank.

And another important point from investment point of view when we compare debt mutual fund to the fixed deposits is that in debt Mutual Fund we pay tax only on the Redemption,

But in case of Bank Fixed Deposit be have to pay tax each year irrespective of whether we redeem our investment or not.

The only benefit or the edge over which fixed deposits have over Debt fund is in case of tax saving fixed deposits, where an individual taxpayer gets a benefit of exemption of up to 1.5 lacs under the section 80c of income tax but this exemption is not possible in debt fund.

But here also there is a twist the returns on the tax saving deposits are tax according to the Tax slab.

The next question comes in investor’s mind before investing in debt fund will be, are these funds really risk free?

The answer of this question is a big no even the debt funds are not completely risk free, but yes they carry a very less risk compared to the equity fund.

The debt mutual fund carries important risk which can affect their return to a great extent, and these risks are

  1. Credit Risk
  2. Interest Rate Risk
  3. Liquidity Risk
  4. Inflation Risk

1.   Credit Risk

This is the risk that the issuer of the security (the borrower) is not able to repay the amount borrowed when the securities mature.

Credit rating agencies assign ratings to securities that reflect the risk of such default. Other things being similar, a lower rated borrower would need to offer higher coupon rates to borrow. Arising out of this is a “credit rating risk.

What happens if a “AM” rated security is downgraded to “A”? Investors will now expect a higher return from the security, in line with the higher risk of default. Since the security would already have been issued with a certain coupon, the higher return expectations out of the security can be met only if the price of the security is lowered.

Thus, if credit rating of a borrower is downgraded, then the securities issued by the borrower lose value, If, however, the borrower is upgraded, then the securities gain value.

When the government of a country issues debt securities in its local currency, then it cannot default. In the worst-case scenario, as seen earlier, it can print currency notes to redeem the securities. Therefore, there is no credit risk when the government of a country borrows in its local currency (sovereign borrowings). However, there would be a credit risk if the government borrows in a currency other than its local currency.

Since credit risk is zero, sovereign securities offer the lowest returns in the market. The rate at which the government can borrow for various tenors is called “sovereign yield” and is typically depicted in the form of a “sovereign yield curve”. Similarly, “MA” yield curve can be built, which would be higher than the sovereign yield curve for all maturities. “Term structure of interest rates” assesses the borrowing cost of the government for different tenors, using yield on zero coupon securities as the basis.

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In 2011, Standard & Poors (S&P) reduced the credit rating of the US from AAA to AA+. This is indicative of a view that even the government can default in its local currency borrowing. It cannot print currency notes indiscriminately, because of the hyper-inflation it can trigger. As explained by S&P, the US downgrade reflected the political reality of the ruling Democtrats and opposition Republicans being unable to work cohesively towards addressing the economic problems of the country.

For Example:

ABC Bank who was performing very well for past few years has a very good credit rating of AAA or AA. But when the same bank due to various reasons fails in future to deliver the similar performance then this credit rating is being degraded by these rating agencies like BBB OR BB. And this credit risk increases for a company which is new in market and ready to pay greater interest for their bonds then the established players to attract more investors to invest in their Bond.

2.   Interest Rate Risk (Price Risk)

The Second Kind of Risk Is Interest Rate Risk Before coming to this first let us know how the bond prices rise and fall?

This is the risk that the value of a debt security changes when interest rates in the market change.

Suppose a company has issued  Rs. 100 face value debt securities of one-year tenor offering coupon (interest) of 12% on 1 January 2001. On 3 January 2001, when the interest rates in the market rise by a percentage, the same company decides to issue securities of the same tenor at 13% coupon.

In the above example, will an investor in the security issued on 1 January, be able to sell her security at 100? The answer is no.

>>      In layman’s terms, the earlier instrument has become inferior, and therefore deserves to lose value.

>>      In quantitative terms, people would rather invest the same 100 in the new security that would give them 13%. The investor who has invested in the 12% security will be able to sell her holding only if she can give a buyer a return of 13%. This can happen only if the 12% security is sold at a price which is lower than its face value, in which case the original investor books a loss.

Therefore, there is an inverse relationship between interest rates and market value of debt securities:

>>      When interest rates go up, debt securities that promise a fixed interest become relatively inferior, and therefore lose value.

>>           When interest rates go down, fixed coupon debt securities gain in value.

The extent to which a security changes value when interest rates change in the market is influenced by its modified duration. Modified Duration is not the same as “original tenor (maturity when the instrument was issued — 1 year, in the above example) or “term to maturity (revised maturity after some time has elapsed since issue of the instrument — 2 days less than 1 year, in the above example). It is a calculated number that will be lesser than or equal to term to maturity. The concept of modified duration, and its difference from Macaulay duration.

The coupon that investors receive on floating rate instruments keeps changing in line with changes in the market. This ensures that they do not become relatively inferior or superior in the market. Since the return on the instrument adjusts to the market, there is no reason for such instruments to gain or lose value when interest rates change.

But even floating rate instruments can change in value if the base used by the instrument is not fully representative of changes in the market place. Similarly, there could be demand and supply factors arising out of interest rate views in the market.

For example

ABC company that pays out the interest rate of 8% per annum on their bonds but at the same time RBI decreases the interest rate in their monetary policy to release more money in the economy and the new Bond issued by the same company will it start getting issued at the rate of 7%. so the old bonds will be looking much more attractive now then the new bonds in terms of returns, and if the same rate cut continuous by the central bank then people will start buying older bonds instead of the new Bonds and this will increase and raise the price of older bonds of ABC company in the bond market and the mutual fund that holds ABC Bond will find their holding very attractive and this is how by selling the older bonds they could make additional profit for their mutual funds.

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So in nutshell we can say that Bond price hold the inverse relationship or it is inversely proportional to the interest rate decided by the central bank of the country when the interest rate Falls the demand of the higher interest rate bonds increases in the market and when the interest rate increases in the market interest rate promise for this bonds would not seem attractive and hence the demand of the bonds in the bond market will fall and therefore the price of the bonds will decrease and give lesser Returns.

And higher the maturity Period of the bonds more sensitive they will be to the interest rate for example the risk in Debt securities of maturity period of 10 years will be much more than that of overnight on liquid funds which have maturity of not more than 90 days. And therefore the short-term maturity bonds can bring down your risk level in debt Mutual Fund a great extent.

And this is how the interest rate risk affects the debt Mutual Fund.

3.   Inflation Risk

“Americans are getting stronger. Twenty years ago, it took two people to carry ten dollars’ worth of groceries. Today, a five- year old can do it: Henry Youngman.”

Jokes apart, inflation is a serious risk for the debt investor. If the inflation rate turns out to be higher than the return earned on the debt investment, then in real terms, the investor would lose money.

Equities, on the other hand, are considered a hedge against inflation. While selling prices of companies’ products rise with inflation, costs do not increase proportionately. Thus profits increase, and equity share prices go up in moderately inflationary situations. If inflation is severe, then consumers may reduce the consumption. Thus companies’ profits may not increase and equity may not protect against the high inflation.

4.   Liquidity Risk

And at last but not the least the debt fund also carry liquidity risk because of the low volume trade in that related securities.

Liquidity risk refers to the difficulty to redeem an investment without incurring a loss in the value of the instrument. It can also occur when a seller is unable to find a buyer for the security. In mutual funds, like ELSS, the lock-in period may result in liquidity risk. Nothing can be done during the lock-in period. In yet another case, exchange-traded funds (ETFs) might suffer from liquidity risk.

As you may know, ETFs can be bought and sold on the stock exchanges like shares. Sometimes due to lack of buyers in the market, you might be unable to redeem your investments when you need them the most. The best way to avoid this is to have a very diverse portfolio and to select the fund diligently.

5.   Re-investment Risk

An investor has invested Rs. 5,000 in a 2-year security that gives 10% interest every year.

At the end of the first year, she would earn T 500 as interest, which, if she deposits in a bank at 10%, would yield Rs. 50 at the end of the second year. This would be in addition to the interest for the second year at 10 % on Rs. 5,000, which would be paid by the issuer.

During the second year, the Rs. 500 received as interest from the issuer, together with the T 50 received as interest from the bank on the first year’s interest, would mean a return of Rs. 550 on a base of Rs. 5,500, which represents investment plus first year interest — an effective return of 10%.

Thus, at the end of the 2nd year, the investor would be left with Rs. 6,050 as follows:

Principal Redemption Rs. 5000
Interest for 2nd year on original investment Rs. 500
Deposited in the bank in 1st year from interest earned Rs. 500
Bank interest on 1st. Year Interest Rs. 50

Obviously, the terminal value of Rs. 6,050 is subject to her being able to invest the first year’s interest at 10%. If she is able to earn an interest of only 8% on the first year interest of Rs. 500, then she will be left with only Rs. 6,040, thus giving an overall return which is lower than 10%. However, if the first year interest of Rs. 500 earns an interest of 12% in the bank, then the closing value of Rs. 6,060 ensures an overall return higher than 10%.

Re-investment risk is the risk arising out of not knowing the interest rate at which moneys received during the tenor of a security can be re-invested. Depending on market conditions at the time of each such re-investment, the effective return on a security can either be lower or higher than what was envisaged when the investment was first made.

Zero coupon securities do not entail any cash flows during the tenor of the security. A typical structure, for instance, would be to invest Rs. 5,000 upfront and get back Rs. 6,050 at the end of 2 years. When there is no cash to re-invest during the two-year period, there is no re-investment risk.

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6.   “Call” Risk

“Call” option is an option that the issuer of a security retains to prematurely repay the investor. “Put” option, on the other hand, is an option that the investor in a security has to demand premature repayment from the issuer. Such options, if applicable, are announced at the time of the security’s issue.

Suppose an investor has invested in a 12% fixed rate instrument of 5 years, having a call option at the end of 3 years. In such a case, the investor cannot be sure that she will earn the same return of 12% for the entire 5-year period.

If at the end of 3 years, the issuer finds that the instrument can be substituted with a lower interest rate borrowing, then the company may exercise the call option. At the end of 3 years then, the investor will get back her money, which would be subject to a re-investment risk — the possibility of having to re-invest it for the remaining 2 years at a rate lower than 12 %.

Thus, debt investors also need to provide for a call risk, which is likely to materialize if interest rates in the market go down.

The reverse of this is the put risk that issuers face. The risk would materialize if interest rates in the market rise, because investors would then prefer to exercise their “put” option and re-invest the proceeds at the then prevailing higher rates.

7.   Foreign Currency Risk

The moneys that would be recovered in local currency from an investment that is denominated in foreign currency would be subject to exchange rates, which change continuously. If the foreign currency appreciates in value in relation to the local currency, then the investor’s redemption proceeds from the international investment would be higher in local currency terms.

Suppose an investor invests in a bond of face value $ 100, at a time when each US dollar is worth 40. The investor would then pay Rs. 4,000 for the bond. On maturity, if the US dollar is worth Rs. 50, the redemption proceeds would amount to Rs. 5,000 — a gain of Rs. 1,000 on account of exchange rate — which would be in addition to the interest that the investor earns on the bond.

8.   Should We Invest in Debt Fund or Not?

As I have already mentioned in the interest rate risk that longer will be the tenure of Debt instrument the more risky it becomes due to the interest rate risk and other factors affecting debt market securities.

So as a smart investor debt Mutual Fund should be bought for short term goals only, for maximum of three years only, and for financial goals which requires tenure greater than 3 years the equity Mutual Funds and the hybrid funds will be the best choice for the mutual fund investor.

If you are planning to get invested for very short term of 0 to 3 years then you can think of investing in debt Mutual Fund.

Debt mutual fund is also good for the person who Is nearing their retirement, because at the time of retirement it is very much advisable to keep yourself away from equity Mutual Fund and avoid high risk and after retirement Debt mutual fund will be the ideal choice for the mutual fund investors.

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