Mutual funds can be an excellent investment vehicle to help you grow your money and save taxes. However, it is wise to know what is a mutual fund and understand there is a certain degree of risk attached to all types of mutual funds. While equity funds carry a higher risk exposure compared to debt mutual funds, the latter is not entirely risk-free.
The article lists the risks of debt funds you must be aware of before you invest in mutual funds.
- Credit risk
Credit risk refers to the risk of default by the bond issuer in the principal amount and/or the interest of the debt instrument held. Generally, corporate bonds have a lower credit rating in comparison to government securities. You can identify the credit risk of a security by looking at its credit rating given by leading credit rating agencies.
The higher the credit rating, the lower is the credit risk of the instrument. If a credit rating agency lowers its credit rating on a particular bond, it can lead to a drop in its prices and an increase in the bond’s yield. Thus, it makes sense to check the quality of your investment portfolio by checking the credit rating of every investment to lower your overall credit risk.
- Interest rate risk
Price of a bond and interest rate are inversely related. So, if interest rates rise upward, the cost of the bond goes down.
Conversely, the price of the bond goes up if interest rates fall. The interest rate can also have a significant impact on the returns you earn from a debt mutual fund. This is because, when interest rates fall, the price of the bond in which the debt mutual fund has invested goes up, in turn, increasing the value of the mutual fund as well.
Thus, whether you invest for short-term or long-term, it is imperative to keep a lookout on the prevailing interest rate and possible fluctuations in the future. Or, you can also invest in dynamic bond funds where you can change the investment allocation based on the current economic scenario and interest rates.
- Other risks
Other risks of debt mutual funds include liquidity, market and inflation.
Liquidity risk occurs when there are limited trading volumes of a fund, and the fund house is unable to sell the investment as a result of it.
Market risk includes micro and macroeconomic factors that can affect the mutual fund market’s environment.
Inflation risk can negatively impact your returns if the inflation rate is higher than the return on the debt fund itself. This means you could end up with a negative real rate of return.
Consider the risks mentioned above regarding debt mutual funds before you decide to invest in them. SIP in mutual funds can be an excellent way to invest using a systematic and structured approach. SIP investments allow you to enjoy the benefit of compounding and also average the purchase cost of units with multiple entry points.