Mutual funds, given the current landscape, when fixed deposit returns have inched higher by only few basis points are a better alternative. More so if you have a low risk profile you cannot go beyond the debt based mutual funds which too carry some inherent risk. So, following are some of the risk that comes with investment in debt mutual funds:
1. Interest Rate risk: Interest rate in the economy and the bond price share a negative correlation. So in case there is an increase in the interest rates then the bond value falls and viceversa. Interest rate situation is hence to be adjudged properly or one can consider investing in dynamic bond funds wherein fund manager taking view of the interest rate situation changes his asset allocation strategy.
The investment in such mutual funds is made in bonds, NCDs and other fixed income bearing instruments of both corporate as well as govt. The investment is made in very highly rated instruments.
For taxation purpose, in case of short term capital gains when redemption is made within 3 years time, tax liabilities arise as per the slab rate of the concerned while in the other case i.e LTCG it attracts 20% tax with cess and indexation benefits.
So as a cautious step, in a rising interest rate regime, invest in short term debt funds and avoid long-term funds for reducing losses.
2. Credit risk: The rating by credit rating agency is another criterion that cannot be ignored as it likely indicates the possibility of default by the bond issuer. Fund with the stable portfolio is ideally the best and one must look at the securities in the funds' portfolio in respect of the rating by the credit rating agency.
In a general case, when the rating of the fund is downgraded, bond price moves lower in tandem but yield goes higher.
3. Inflation risk: Other associated risks such as market-linked risk, liquidity and inflation risk are also to be factored in before betting on a debt mutual fund. In a rising interest rate regime when inflation is triggered, you may be hurted with your investment in debt mutual funds by getting negative real return on your investment from debt mutual funds.Also in such a situation, bond prices take a hit and bond yield goes higher.
Liquidity risk is another criteria and before you take a dig into a debt mutual fund, do note of its likely ease of liquidation.