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What are the risks in debt funds?

Be cautious about investing in the best-performing debt fund, as there will be some risk, says Dhirendra Kumar

What is your prediction on the movement of interest rate over a time horizon of three years? In one of your hangout sessions, you have said that as a rule of thumb, one should avoid the best debt fund. Given that, will Kotak Bond - Short Term Fund be a good investment opportunity, as it shows a 5-star rating on Value Research?
- Ayush Maniar

Answering the second part of your question first, I haven't looked at Kotak Bond - Short Term Fund very closely but generally speaking, a debt fund that has delivered extraordinary returns requires much deeper analysis. Any extraordinary high returns in debt funds will come with higher risks. There are three kinds of risks which a debt fund can assume. One is credit risk, i.e. investing in lower-quality bonds. The other way funds generate higher returns is by taking interest-rate risks. Here, fund managers invest in long-maturity bonds if they believe that interest rates will go down. When interest rates go down, the longer the bond maturity, the higher the appreciation will be, as those bonds will pay you higher interest rates for a longer period of time and thus, will become very pricey. And the converse is also true. The third type of risk is liquidity risk. Some funds may invest in bonds that aren't actively traded and thus, be valued differently, which may make it difficult to sell those bonds before their maturity. So, there are financial nuances, which can lead to higher returns by assuming liquidity risks.

Fund managers may assume such risks on a small part of their portfolio but in bad times, that small part turns big when investors turn out to pull their money out. So, I stand by my statement that one should be cautious about investing in the best-performing debt fund on the assumption that there will be some risk.

Regarding the first question, I would say that even in relatively normal times, I have seen bond fund managers going substantially wrong with their predictions on interest rates. Right now, I visualise that interest rates can go down a little further in the short run. However, I don't know about the rate trajectory over a period of three years, as we are still in the positive interest rate territory. And I don't know how the economy will pan out from here on - what kind of decline we are going to see, what kind of steps the government will take, or the RBI will take in tandem with the government. So, it's very difficult to guess but I hope that we are back to normal times.