With the volatility in government securities/bond prices over the last few weeks, investors have started realising the risk of investing in an income/gilt fund.

Investors had a misconception about the working of income and gilt funds. Many investors perceived these funds as "very safe" investments providing steady returns. However, its only now they have started realizing the risk of investing in debt funds with increasing volatility in the bond market. It is necessary for an investor to understand the factors that dictate the performance of a debt fund. We have tried to highlight some of the risks associated with a debt fund and how can they be eliminated.

1. Credit risk:  A debt fund typically invests in corporate debt, PSU (public sector unit) bonds, gilts and money market instruments. The investment in corporate debt can be risky as the issuing company may default in its interest payments or may go down completely. This risk cannot be eliminated completely but can be reduced by investing in relatively safe i.e. 'AAA' rated companies. Gilts funds do not carry credit risk as gilts have a sovereign rating  i.e. backed by the Government of India.

2. Price risk: Price risk arises out of trading (purchase and sale) of debt securities in the secondary market. This risk can be eliminated to a large extent by the fund manager's expertise in managing his funds.

3. Event risk:  Risk arising from any disastrous event (natural calamity, war) taking place in the country that could have a negative impact on the economy is an event risk. This risk cannot be eliminated as it is very uncertain and is rooted in future events that no one can predict with any degree of uncertainty. However, it can be curtailed by the fund manager's expertise.

4. Interest rate risk:  The most difficult and complex risk associated with a debt fund is that of interest rate risk. A rise/fall in the interest rates can have a significant impact on bond prices as also the NAV (net asset value) of the fund. This risk can also be minimized by the fund manager's expertise.

The last risk component “ interest rate risk"  is indeed the most difficult and its something that fund managers (and investors) have to live with throughout the life of the fund. In other words, it's a risk that cannot be eliminated at all. From a layman's perspective, that's a matter of concern and if he is a 'safe 'investor his main objective would be curtail interest rate risk to the maximum possible extent.

First lets see how an income fund's net asset value (NAV) can get affected by interest rate fluctuations. The Income Fund has invested in 'ABC' Corporate Bond. Every bond paper consists of three components, the coupon rate, the price and the tenure. E.g. 10% ABC 2005 is available at face value " this means the company has promised to pay a fixed return of 10% p.a. to the fund till the year 2005 and currently Rs 100 is the price of 1 bond of the company.

ABC Corporate bond	Rate of Interest	Price (Rs)	Fixed Return (Rs)
Initial offer	10%	100	10
Interest rate rise	11%	91	10
Interest rate fall	9%	111	10

The table shows the working of the bond price in the event of a rise or fall in the interest rates. It is evident from the table that if the interest rates rises i.e. 11% in this case, the price of that corporate bond would fall to Rs 91 (as also the fund's NAV) in order to give a fixed return of 10% p.a. i.e. Rs 10. However, if the interest rates fall i.e. 9% in this case, the price of the bond will shoot up (as also the fund's NAV) to Rs 111 to give the same amount of interest.

As is evident, the rise or fall in the interest rate can have a significant impact on the funds NAV.

To eliminate the interest rate risk income funds are witnessing a new concept of 'Floating Rate' with Franklin Templeton Fund being the first fund house to launch a fund on these lines Templeton Floating Rate Income fund. The fund will not invest in instruments, which give a fixed rate of return, but will invest in instruments that offer a floating rate of return. In case of the former, the coupon rate was fixed because of which the price of the bond fluctuated as did the NAV of the fund. But in case of the floating rate fund, the coupon rate itself fluctuates as per the current benchmark rate for the debt securities e.g. MIBOR (Mumbai Inter-bank Offer Rate). This takes care of the capital of the investor and gives him a hedge against interest rate volatility.

PersonalFN provides research recommendations to its premium research subscribers and financial planning clients. To know the recommendation on this investment, become a subscriber or client today. Click here to know about our research services. or Click here to know about our financial planning services. Or, simply write to info@personalfn.com. You can also call us at +91 22 6136 1200.

Add Comments