There is a popular view that while share investments and mutual funds investing in shares are risky, debt instruments such as debentures and other forms of corporate debt and mutual funds investing in such debt are safe investments. Let us understand this proposition.

What are the Risks of Investing in Corporate Debt

Corporate Debt comes in the form of debentures, commercial paper, fixed deposits, etc. Corporate debt and by extension, mutual funds that invest in corporate debt, carry all the risks of investment that shares carry. There is a risk of non-payment of interest payment, non-repayment of the principal amount, delayed payments, and spending on legal procedures to recover amount not received or delayed.

Corporate Debt may be secured or unsecured. Secured debt is that which has been mortgaged against an asset of the company. It is not practical for individual investors or even mutual funds to assume that secured debt is safe.

Banks for instance lend to banks. Most of the banks that have lent money to companies today face a situation where the company is unable to pay either the interest or the principal or both. The total amount of such dues runs into lakhs of crores of rupees and the banks are negotiating with the companies to at least return a part of the amount due with a promise to write off the remaining part of the loan. When banks with all their power cannot recover the money rightfully due to them, mutual fund organisations and individuals stand no chance of recovery when things go wrong.

Because of such risks all debt instruments are rated for the degree of risk they carry. the rating is given on a scale ranging from AAA at the top (Highest Safety) to D (Default). In between are AA, A, BBB, BB, B, and C. As we go from AAA to other categories, with each category the risk level increases.

Tinesh Bhasin writing in the Business Standard in Personal Finance Section, Monday 28 August 2017, tells us that in BOI AXA Corporate Credit Spectrum Fund more than 45 % was invested in A or less than A rated corporate debt. Similarly in another 2 Funds, Franklin India Dynamic Accrual and in Franklin India Income Opportunities, the percentage of investments in corporate debt rated A or less was more than 50 %. The reason mutual fund managers invest in lower rated corporate debt is the belief that the higher risk investments (or lower rated corporate debt) may give a higher return. But first let us understand why most people believe that debt mutual funds are less risky.

Why does the popular perception persist that corporate debt is less risky?

It is useful to know why the notion that debt instruments are less risky than shares exists in common perception. In a debt instrument the rate of interest is known. Hence we can say that the uncertainty of how much we will earn from the investment is removed.

On the other hand in the case of shares the rate of return is not known. When an investor purchases a debt instrument the rate of interest payable on that instrument is indicated by the company. This removes the uncertainty of how much an investor will earn by investing. In a share investment the investor does not know how much dividend the company will give or whether the company will give dividend or not. Equally uncertain is whether the share price will go up or down.

Certainty of the rate of interest on a debt instrument does not reduce risk. In finance risk and uncertainty are two different concepts. Just because there is a certainty of what the rate of interest is, there is no guarantee that you will get it. Assuming that the risk is reduced because the rate of interest is known, is wrong. The risk of not receiving the interest payment exists, the risk of not receiving the principal amount exists, the risk of delayed payments exists and the risk of spending on court cases when things go wrong exists. The recent financial crises brought about in the market is because of IL & FS defaulting on its debt that it owes to the market. As a result of these defaults, mutual funds holding the IL & FS debt in their funds, have put a severe strain on the NAVs. (Click here to know what the mutual funds are doing about this problem)

Additional risk with debt mutual funds

Another aspect of how much money of the fund is invested in lower or higher rated corporate debt is the percentages keep changing. Hence at a particular point in time when you check the Fact Sheet on the
Fund’s website, you might observe that most of the money is invested in AA or AAA rated corporate debt. But with changing market situations, or under pressure to try and get better returns, the fund manager may take a decision to invest in lower rated corporate debt. Many of the debt funds invest in lower rated corporate debt in the hope that they will get higher returns and therefore be in a position to report a higher NAV. So one has to continuously and constantly be checking the Fund’s website to get such information.

But the very essence of risk is: the higher the expected return, the higher the risk. Very often projections are made on mutual fund returns without explicitly stating the risks involved. It is brushed aside with one take all statement: Investments in mutual funds are subject to market risks, without any attempt to explain what those risks are. Worse the statement is made in the TV or radio something like this: mutualfundsaresubjecttomarketrisks – as if it was one word. It is probably the longest word in English language!!!!!

In most cases the adviser who recommends a particular fund to purchase will not be having this information, and the adviser most definitely does not keep a track of this information on a regular basis, leaving the investor to face the risks and the consequent financial loss. Most investors in mutual funds do not know the unknown risks they are facing. Like heart disease is known only after it reaches a certain point, so to mutual fund risks. We know of it only when the risk attacks us.

Be Confident

As life insurance salespersons the next time your customer raises the objection of investing in mutual funds, use the information given above freely and educate your customers of investing in mutual funds. Tell your customers that they are putting their money in the hands of persons who are not accountable to protect their money and they are putting their money in a market where even large institutions like banks find it difficult to recover their loans. Also tell your customers why debt funds are not as safe as they are made to seem. You are protecting your customer’s money. Investment in life insurance endowment is safe.