Are debt funds risk free?

A significant portion of investors chooses debt funds for their mutual fund investment due to their comparatively lower risk. But are they completely risk-free? This is a common confusion among investors and there are a lot of myths around this topic as well. Through this article, let’s try and understand debt funds and examine if they are completely risk-free.

What is a debt mutual fund?

A debt fund is a mutual fund that invests primarily in debt-based securities. Also known as income fund or bond fund, they give you profit through investing in fixed-income securities like corporate and government bonds, corporate debt securities, money market instruments, etc. They offer slow yet steady capital appreciation.

What is the risk associated with debt funds?

Since only a small portion of debt mutual funds’ portfolios is dedicated to equities, the risk associated with a debt fund is comparatively lower than an equity fund. Debt securities offer you profit through fixed interests and hence there is a relatively lesser chance for them to be volatile.

But does that mean debt mutual funds are completely risk-free?

No. It is comparatively less risky but there is still risk involved. These funds invest your money in debt and money market instruments that could face different risk factors compared to an equity fund. Debt funds face interest rate risk, credit risk and liquidity risk, which is uncommon and less heard of compared to risks associated with stock markets. These risks are lower compared to an equity investment which could turn volatile, but it cannot be ignored. Let’s take a look at different debt fund risks in some detail.

• Interest rate risk

It is simply the potential loss of money that could occur due to a change in interest rates. If the interest rates go up, the value of the bond or any other debt security will drop. Such a change in a bond’s price due to a drop in the interest rate is called duration. If this scenario happens, the debt fund could take a hit as well. Just like with stocks, the price of the bonds will decrease, which in turn will reduce the price of the mutual fund’s NAV, resulting in a loss for the investors.

• Credit risk 

Credit risk is a potential loss that could happen if the borrower fails to repay a loan or meet a financial contract. Here, a debt fund will suffer a loss when the issuer of the security defaults on the payments. Payment defaults are more common with mutual funds that invest in lower-quality securities and hence, many investors tend to avoid funds with lower quality securities. But, at the same time, there is a type of mutual fund known as credit risk mutual fund which primarily invests in low-risk securities to leverage higher interest rates.

• Liquidity risk

Debt mutual fund investments could be prone to liquidity risk as well. Just like a stock market, debt instruments are traded in a market too. The major difference is that the stock market is more transparent and you, as an investor, can track its movement anytime. But debts are sold between companies and governments and much of the information about that is not readily available. Here, there could be situations where debt securities become hard to sell due to lesser demand. This usually happens due to tough market conditions and could result in a situation where the fund is not able to pay the investors.

How to buy a low-risk mutual fund in India?

Now that you have understood the risk associated with debt funds, buying MF online is easier than ever nowadays. Do your research and find the fund of your choice and you can invest in a matter of minutes!