Credit Risks Of Bond Funds

An Intro:

Investing in mutual funds come across as very rosy. However, when the risk disclaimers come in, one would be well advised to heed them. Investors often look towards bond or debt heavy funds when the markets are volatile. Stock prices seem to undergo wide range and hence the debt funds look more amenable. However, the risks involved there are also very real.

Perceptions:

The common idea is that a bond mutual fund will mean worrying about the interest rate risk alone. Many investors consider them as safe as savings accounts and even fixed deposits. However, they discount the fact that even the safest, most liquid, best of portfolios have seen negative returns. Most investors also look over the risk of credit, which entails the companies not paying the sums due on the bonds. This would mean, the mutual funds not meeting the desired returns and may also result in capital erosion. Bond mutual funds usually involve lower returns and risks as compared to their equity counterparts. Money market mutual funds offer higher returns but very little guarantees.

Risks:

Corporate bonds offer high returns in the form of debentures. These bonds or debt funds usually have a two dimensional risk angle. One is the very basic Interest rate risk which basically means that the return in the form of interest earnings will become lower than the future rate of interest. This will directly affect the price since the Yield to market rate will become impacted. However, in times of mergers and acquisitions and closures, a credit risk or default probability on the principle sum is also a very clear and present danger. Investors here also face prepayment and inflation risks.

Identification:

When investing in bond funds it is critical to look at the rating. The rating of AAA is high while A is low. There are some which offer very high pay outs but are unrated. Thus, lower the rating, higher the return but also higher the risk. Hence, one must be very strict with maintaining risk appetite. Credit risk or capital risk can also be judged if one is able to look at the type of paper instruments the fund is investing in. If the higher return comes at the price of investing in low grade paper instruments then that is cause for concern. Hence, while investing it is essential to look at the quality as well as the maturity of the bonds. If the bond has longer maturity, it is bound to offer higher yields. However, the length of maturity will change the weighted average risk involved.

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