It is usually assumed that debt funds are safe to invest in as compared to equity schemes, which is true to an extent. This is because the volatility in stock prices in much higher than the fluctuation in interest rates. But debt funds do have two risks associated with them, one is the interest rate risk and the other is the credit risk. So these funds are not as safe as one might assume them to be, so let us try to figure out what these two risks entail for an investor.
The interest rate risk is the risk that comes with the movement in interest rates in the financial market, so when the interest rates go up, the bond prices go down and, as a result, the NAV of the fund that has invested in a debt instrument too goes down. On the other hand, when the interest rates go down, the bond prices go up thereby raising the NAV of the fund. The lower the NAV, the lower the return on investment, and higher the NAV, higher the return. So the impact of the movement of interest rates is real for an investor.
The credit risk is the risk of default by the bond issuer in repayment of the debt. This is a more serious risk than the interest rate risk as a default by the issuer can cause a loss to the mutual fund that has invested in the debt instrument of the defaulting issuer. If the exposure of the mutual fund to the debt instrument is high, the damage to the debt fund can be serious.
Hence, to avoid ruining investments in debt funds, investors need to avoid investing in debt funds that have large exposure in low quality debt instruments. The quality of the debt instrument can be easily ascertained by looking at the ratings by the credit rating agencies of the debt instruments in which the mutual fund house has invested.