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Asked your advisor about credit risk?

Here is what you need to be on the lookout for to avoid taking too much risk in your debt fund.

If you haven’t done that ever, then now is a good time to start. Ask your advisor about credit risk. Credit risk refers to the risk you face from investing in a poor-quality bond, where there is a chance that either interest payments or principal repayment or both may suffer due to cash flow issues. 

Now you may not invest in bonds directly, but debt mutual funds scheme you invest in also buy bonds and they might invest in low-quality bonds. We are discussing this today because of the mishap in six of Franklin Templeton’s debt schemes which are stuck in this highly risky phase. The funds are being wound up and investors can’t exit. This holds true even for schemes where the guideline was liquidity or 6-9-month time frame for exits. 

Here is what you need to be on the lookout for, to avoid taking too much risk in your debt fund. 

In this case, the bond selection is key just like the stock selection is key in an equity fund. Where you are certain you want zero risks in your debt exposure, only choose funds with 100% AAA bonds. Lean on your advisor to help you do that. 

Look at the quality

Mutual funds publish their portfolios every month, you and your advisor can access this on the fund’s website and see what the portfolio looks like. 

In a debt fund, securities will be rated as AAA, AA, A and so on.  AAA is the highest-rated credit which means the safest bonds in terms of repayment of principal and timely interest payments. Government-issued bonds are AAA rated, as repayment is not a concern. Fund managers buy lower-rated bonds as they come with a higher yield or interest payment. Which means they can bump up returns and the fund gets more attractive. That’s why fund managers do add some bonds which are not AAA-rated even in debt funds meant for stable returns. 

In this case, the bond selection is key just like the stock selection is key in an equity fund. Where you are certain you want zero risks in your debt exposure, only choose funds with 100% AAA bonds. Lean on your advisor to help you do that. 

Look at concentration

The other aspect is concentration or the amount the fund invests in one particular bond. High concentration means a high allocation to one bond which can make the outcome riskier when it comes to selling that bond. This is no different from say high exposure to one stock in an equity fund, making that riskier. Avoid funds with high exposures to single securities. 

High exposure to Central Government securities is fine as they can be sold easily in the secondary market. Other than that, look at the single security exposures in a scheme and avoid funds with concentration risk. 
These are basic guidelines which will help you steer clear of high-risk debt funds. Ask these questions to your advisor and understand whether the funds being recommended also steer clear from these risks. 

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