Recently, I came across an investment advisor, who was analysing the portfolio of a fixed maturity plan launched by a certain mutual fund house. The advisor knew quite a lot about the fixed income market and hence could grill the representative of the mutual fund company. He finally decided not to get his client’s money invested in the scheme since the exposure to “AA” rated debentures was higher than his comfort. Now the same advisor had mobilised lot of money into the debentures of a certain NBFC. The debenture carried “AA-” rating.
The problem here is of someone seeking certainty but lacking clarity. The interest rate offered by the debenture looks certain. However, one must consider the credit risk associated with the debenture. The credit risk is the possibility that the company may not be in a position to pay either the interest or the principal or both on time.
Certainty assumes a no-risk situation; clarity understands no-risk is a fantasy. The clarity is about the risk involved in investments. Understanding of risks is very important for any investor. There are three different points to consider:
1. Diversified portfolio vis-a-vis single instrument
2. Assured return from debentures vis-a-vis no assurances in a mutual fund scheme
3. Underestimating credit risk but overestimating interest rate risk
What does a debt mutual fund do? Well, it buys debentures issued by various companies. And that is where one of the risks comes down. When an investor buys debenture issued by one company, the investor is exposed to the risk that the company may not be in a position to pay either the interest or the principal or both on time. A mutual fund, on the other hand, is required to diversify the portfolio by investing in debentures issued by different companies. Such a diversification means that the risk of losing all your money is low as all the companies will not default simultaneously (or at least, the probability of such a thing is very low). Investment in a diversified portfolio is lot safer than investing in one single security.
Another point to understand is that a debenture is a contract between the issuer (borrower) and the investor where the terms of the contract are defined. The issuer takes the investor’s money and promises to pay the principal and interest on it as per a defined schedule. On the other hand, the investor in mutual fund owns the units of the fund and is not assured of any returns. This is quite discomforting for most.
How can one explain that the returns from a debenture are known but those from a mutual fund buying those debentures are not? That happens because of the differences in accounting practices.
Most investors do not look at the prices of debentures on a regular basis. They normally invest in debentures only to be held till the debenture’s maturity. What happens to the price in between does not concern the investor. In fact, the investment is also made with the clarity that the money will not be needed before the debenture matures.
NAV of mutual fund is calculated as per the market valuations of the securities. For this, the debentures in the portfolio have to be valued at prevailing rates on a daily basis. Due to this, the NAV fluctuates in line with the changes in the prices of debentures. The biggest contributor to this change in prices of debentures is the change in interest rates.
That brings us to the third point, i.e., underestimating credit risk and overestimating interest rate risk. Interest rate risk causes the fluctuations in the NAV discussed in the previous paragraph.
The price fluctuations happen very regularly, whereas the defaults do not happen very often. What happens very frequently is perceived by the mind as high risk as compared to something that does not happen so often. However, fluctuations can result in lower returns for the investor or marginally negative returns, but default risk may result in loss of all the returns as well as the capital. The interest rate risk is lower if the investor has a long holding period, but the default risk is higher if the investment is for long term.
These differences between these two risks must be understood in order to take informed investment decisions. Whereas the probability or the frequency of a negative result may be high or low, one has to also consider the impact if such an event happens.
The clarity in investment suggests there is nothing called certainty. The learned investment experts always mention that all investments are subject to risks.
Happy investing to all!