Debt mutual funds are not as safe when compared to FDs. There are certain types of risk in debt mutual funds like the credit risk, interest rate risk and the liquidity risk. It is more often difficult for a new investor to understand these financial jargons associated with debt mutual funds. So, let me start by explaining a simple debt story which you can relate to your daily lives.
Assume that there are 3 friends in a city. Let us name them as A, B and C. One day, A and B were sitting in A’s house and were talking over a cup of tea. During discussion, B asked A if he could lend him some money as B was planning to expand his business. Since they were good friends, A agreed to give him a loan after a week. They both agreed on the following conditions:
A will lend an amount of 1 Lakh to his friend B for a duration of 1 year.
The interest charged would be 10% per annum.
B will pay a monthly instalment of 1,000 per month (interest amount). At the end of 1 year, B will return the principal amount of 1 Lakh to A.
Now, tell me what would be the first thing which will come to your mind if you are in the place of A who is lending money to a friend?
The very first thing which came to A’s mind, naturally, was that what if B will not be able to return 1 Lakh after a year or what if B will not be able to pay the interest. I am pretty sure that this would be the first thought which will come to your mind as well, if you lend money to a friend. What is this Risk Called?
This is called Default Risk.
Default Risk – When a borrower is not able to return the interest and principal amount, it is called default risk. There can be various reasons of defaulting the payment. A recent example of the same, can be COVID-19, where a number of businesses had been shut down.
Assume everything is going fine in B’s business, and on one unfortunate day, one of the social media influencers write a very bad review about B’s business. The words spread like fire and there is a sudden decline in B’s business. The news of the declining business also reaches to his lenders (from where he used to source his raw material on credit) and his lender stops giving him the raw material on credit. The credit worthiness of B’s business is declined overnight. What is this risk called?
This is called Credit Risk.
Credit Risk in Debt Mutual Funds
Credit risk occurs when credit worthiness of a certain business is declined. The case of DHFL, where the company’s rating was downgraded drastically, and it was not able to meet its debt obligation can be an appropriate example for this type of risk which has happened recently. In most of the cases, it is the credit risk which normally leads to default risk, while at the same time, it is not necessary that company’s rating downgrade will result into default risk.
Now imagine a third scenario where everything is going well. B is paying the interest on time and A is sure than he will give the principal amount back on time. A’s another friend C approaches and asks him if he could lend 1 Lakh for his business expansion. C offers an interest rate of 15% per annum on 1 Lakh. A is in a dilemma now. A starts thinking if he had made a mistake by lending 1 Lakh to his friend B at an interest rate of 10%. This is a risk which A thought never could happen. What is this risk called?
This is called interest rate risk.
Interest Rate Risk in Debt Funds
This kind of risk happens when you have already given a loan at a specific interest rate but due to changing economic conditions, the interest rates are higher now and you have no other option but to accept the loses since you have already given loan at a lower interest rate for a certain period.
Please note that it can happen both ways. Interest rates can go in either direction. It can either rise or may fall.
Moving on, let us come to the fourth scenario. A has lent an amount of 1 Lakh to his friend B. After a month, A is in an emergency and needs 1 Lakh immediately. A went back to B and asked him to return his money, but B is not able to give him the money back since he has already invested the amount for the expansion of his business.
Left with no other options, A goes to his friend C and asks him if he could lend an amount of 1 Lakh. A suggests him to take 1 Lakh from B after 1 year with interest payment every month. Ideally, A is transferring his agreement to C. But C says that he will only pay 90,000 for transferring the agreement, otherwise C would not be able to lend 1 Lakh to A. What is this risk called?
This is called liquidity risk.
Also Read: Mutual Fund Taxation 2020-21
Liquidity Risk in Debt Funds
When you are not able to sell your securities in market, it is called liquidity risk. Even if you can sell it, the chances are that you will sell it at loss because of the illiquid nature of securities.
Imagine the first scenario again where B borrowed 1 Lakh from A. Let us put some twist here- In addition to the agreement, A asked B for some collateral as security to lend amount of 1 Lakh. B had purchased a bike recently worth 1.20 Lakhs and agreed to give this bike to A as collateral.
After 2 months, B started defaulting on monthly interest payments. After waiting for another 2 months, A decided to sell B`s bike. When he went to market to sell the bike, the resale value was only 80,000. Since there was no other option, A sold the bike at a price of 80,000. In this situation, there is a loss of capital even after having an asset as collateral. What is this risk called?
This is called Asset Risk.
Asset Risk – In this type of risk, you have the right to sell assets if the borrower defaults. Here, the lender may lose both its capital and the asset even after selling the asset.
These are the very basics of types of risk in debt mutual funds. The example of 3 friends that I have chosen here is to simplify the concept of risks. You can associate it with the corporate world.
Do let me know if you have any queries.