Debt funds have been under the risk radar of investors since August 2018. When the ILFS default happened, a lot of debt funds were hit by it and many had to opt for side-pocketing to save the investors. However, many thought it was a one-off incidence and things will get back to normal. However, the recent episode of closure of six debt funds by Franklin Templeton has brought the issue to the fore again. What it means that you can no longer ignore the issue and take safety of debt funds for granted. You will need to do proper research before committing your hard-earned money to any such investment. We tell you the questions that you must find answers to before signing the investment cheque.

Why has your selected fund given higher return?

The first instinct which many investors have is to select a fund that has given superior return. You may be in for a trap unless you investigate it. While there are many funds which genuinely benefit from smart investments and favourable interest rate movements to generate high returns, however, there are also many other debt funds that invest a good part of their corpus with low quality debt securities which give very high return. As a result the average return of the portfolio goes up. However, these low quality papers can potentially lead to a big loss in entire portfolio, as has happened in the case of Franklin Templeton. So before getting swayed by high returns you need to know the reason behind them and if it is because of low quality paper you should know that the fund has higher risk.

Credit risk is the biggest risk that a debt instrument faces. Basically it is the risk of default by the entity which has borrowed money by issuing debt instruments. Greater the risk of default, higher is the interest offered by the issuer to the investors. All debt issuers are required to get their organisation evaluated for financial strength to service the debt, which are then assigned a credit rating accordingly. Therefore, before investing in debt fund you must have the answer as how much part of the debt fund portfolio is invested in low credit quality papers.

How interest rate movement will affect your return?

Interest rate keeps changing with changes in overall economy and debt securities are exposed to this interest rate volatility. If you have entered the market when the interest rate is higher, then you are bound to benefit when the interest rate falls. With any fall in interest rate the price of debt securities typically goes up which enhances the return for the investors. However, if the opposite happens and interest rate goes up and then the prices of debt securities come down which results in lower return or sometime even a capital loss for the debt investors.

Do you understand the maturity profile of the debt fund?

A debt fund is collection of many debt securities which can have varying levels of maturity period. Longer the maturity period greater would be the holding period and hence your investment will be exposed to uncertainty for longer period. With time situation may change significantly as many companies which are appearing strong right now may become vulnerable going forward.

What if you are holding a debt paper with 10-year maturity, but 5 years down the line the financials of the company start deteriorating? Holding till maturity option would increasingly become riskier and hence the prices of the debt paper will fall, resulting in loss for the investor if he decides to sell it in the secondary market where debt securities are traded. Therefore, longer the duration risk that you are taking stronger should be the debt securities portfolio of your desired debt fund.

If you are new to debt fund investing you should ideally stay away from investing in any fund that is taking greater credit or duration risk. "Layman retail investors looking for a more liquid and tax-efficient alternative to FD should stick to Liquid and Ultra Short Duration Debt Funds only. Retail investors should stay away from debt funds that take credit risk or duration risk as that could lead to losses or volatility in their debt investments" says Ankur Choudhary, Co-Founder and Chief Investment Officer - Goalwise.com.

Do the low duration funds have no risk?

Low duration funds are considered relatively safe when compared to long duration fund but only with some conditions. These funds typically hold debt securities with maturity profile of not more than 1.5 years. But many of low duration funds also invest in low credit debt to boost their earning which make these funds also vulnerable to the default. When the market faces redemption pressure these funds witness higher exodus of investors as is happening in current market situation. In case of lack of liquidity these funds also face the risk of being shut in case of huge redemption pressure. "Risks associated with low duration funds make it very important for every investor to understand them before investing on the name sake of being a debt scheme with an ability to generate high returns" Gurmeet Singh Chawla, Director Master Portfolio Services.

What is the liquidity risk in the fund that you are investing in?

When there is panic exit by many investors is the quantum of liquid investment that saves the day for a debt fund. More liquid debt instrument a debt fund has in its portfolio greater will be its ability to handle redemption pressure. If a debt fund has lower level of investment in liquid paper it will remain vulnerable to any redemption pressure and may have to go for distress sell or other securities which may hamper the return of the remaining investors.

If you are a savvy investor you need to do due diligence yourself before investing, however if you are not confident about the exercise it will be better to consult an expert. "Retail investors need to understand the risk involved in debt funds and to consult their financial advisors about the quality of securities in the schemes they have invested. This event is a lesson for all the investors that debt schemes also carry some risk and that they need to monitor these investments as well from time to time as in the case of equity schemes" says Chawla of Master Portfolio Services.