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Are your FMPs, and Debt Funds, at risk? What should you do?

It is definitely a problem if you don’t get the amount you expected when a financial security with a defined period and pay-out matures.

When it comes to market-linked products like mutual funds, one has to contend with some amount of market risk, be it debt or equity, open or closed-ended funds.  Debt fund investors face two types of risks, interest rate and credit risk.

Two FMPs (or Fixed Maturity Plans) from a popular asset manager have been in the news for not returning the entire amount due to investors at maturity. Rather, the management has said that the remainder may be paid out at a later date.

It is definitely a problem if you don’t get the amount you expected when a financial security with a defined period and pay-out matures.

Keep in mind that risk is not a bad thing. Returns come thanks to calculated risk; there has to some amount of calculated risk-taking if one wants a relatively higher return. Risk means there is a chance you may lose money, but what does credit risk entail? Read on to understand the impact of credit risk in a debt fund.

What is credit risk?

In return for investing in bonds and debt securities, funds receive a periodic interest payment which gets added to the asset value of the fund. These securities are rated by authorised rating agencies on a hierarchy of their financial worthiness. This hierarchy is relative. For example, a AAA or equivalent rated security means the highest level of safety and reliability in meeting payment obligations.  

Debt funds classify securities in their portfolios on the basis of this credit rating. While ratings keep getting reviewed, at times a payment default happens before the rating gets lowered. This default on payment and subsequent, or prior, downgrade of the debt security to a lower credit grade is known as credit risk.

This impacts two things, firstly the fund holding the security does not get the interest payment due, hence, the total asset value of the scheme suffers to that extent. Secondly, in case of open-ended funds where prices of securities are marked to their market price daily, following a default there is an immediate fall in the price of the security which can then bring the scheme NAV lower too.

If the defaulting corporate entity never repays the fund its dues, you are unlikely to get back the lost value either.

What should you do?


The question really is whether you need to add credit risk to your portfolio for enhanced return? For your regular debt allocation the answer is no; stick to diversified large debt or liquid funds with a proven record of managing risk better with primarily a high credit quality portfolio, low expenses, and those which do not increase your credit risk, especially concentration risk.

If you are invested in a fund with credit risk and the event has happened, there is nothing much to be done, you have to bear the loss if the money can’t be recovered.

The question really is whether you need to add credit risk to your portfolio for enhanced return? For your regular debt allocation the answer is no; stick to diversified large debt or liquid funds with a proven record of managing risk better with primarily a high credit quality portfolio, low expenses, and those which do not increase your credit risk, especially concentration risk.

Holding such funds is not only wiser but in case your holding period exceeds three years you stand to benefit from indexation.

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