The types of risk in fixed income funds are many: interest rate/volatility risk, credit risk, counterparty risk, concentration risk, liquidity risk, etc. But the two major risks, going by the history of fixed income funds, are market/interest rate and credit risks. There are mitigants for all types of risk, and there are two types of mitigants for these. They may sound simplistic, but are effective.
Let’s start with volatility or market risk. There is a one-to-one correspondence between the maturity or duration of the bond/bond fund and market risk: higher the duration, higher the risk. This is not the case in other asset classes like equity/commodities, as there is no defined maturity. What if you just reduce the duration in your portfolio to reduce volatility risk? In mutual fund parlance, if you stick to short duration funds as against long duration funds, what is the downside? Let us look at long period data. A study undertaken by CRISIL-AMFI, over a period of 2001 to 2018, shows that the return from short-term debt funds over this period is 7.63% CAGR i.e. annualised, per year. Over the same period, income funds yielded a return of 7.81% CAGR. The additional return for taking higher volatility risk is only 0.18% or 18 basis points per year, which is not significant. The return from gilt funds, which have even longer duration, is 8.08% CAGR over the same period. There is a reward for higher volatility risk in gilt funds, but again, not huge.
Net-net, if you stuck to short-term debt funds, the “downside” i.e. relatively lower returns would not have been significant. Hence, if you chose short-duration over long-duration funds, over an observation period of 17 years, you wouldn’t have lost much. The usual approach to volatility is reducing portfolio duration when yields are rising and vice-versa, either you do it in your portfolio or the fund manager does it in a professionally managed portfolio. Without taking away anything from the conventional approach, if you decide to avoid long duration, though you would earn less in times of market rally, over a long period you would not lose much.
The other major risk is credit risk. The approach to controlling credit risk is performing due diligence before taking exposure to a security and tracking the issuer post exposure, till maturity. The importance of due diligence for tackling credit risk will always remain sacrosanct. However, one simplistic but effective approach to tackling credit risk is to limit the exposure to one particular instrument or issuer. That is, distribute the portfolio well so that the credit risk emanating from one issuer is only as much. Though diversification is not a new concept, what we are discussing here is not distributing a debt fund portfolio to 10 or 15 instruments, but many more.
One fundamental difference between an equity fund portfolio and a debt fund portfolio is that in equities, most of the returns come from price appreciation, dividend yield being as low as, say, 2%. In fixed income, most of the returns come from accrual and a relatively smaller component comes from price appreciation. That being the case, whether the accrual is coming from instrument A or instrument B does not make as much of a difference. In other words, an equity portfolio can be over-diversified because in that case the benefit of price appreciation from that stock is being limited. However, in debt, the portfolio cannot be over-diversified as contribution of price appreciation to overall returns is anyway on the lower side.
The counter-arguments against wide diversification in debt funds could be that it questions the conviction level of the fund manager on the exposures being taken and it increases the incidence of tracking. However, if the risk is being contained, the damage on account of a relatively lighter due diligence and tracking (due to limitations of team size) is being limited to that extent.
Net-net, investors may consider remaining at the shorter end of the maturity curve, say, 3-year maturity against 10-year maturity, so that the volatility risk is that much lower. Returns will be lower in bullish market phases because long bond funds (gilt and long duration) will outperform, but over a long period of time, the differential tends to even out, as discussed earlier. From the credit risk control perspective, the wider the portfolio is spread out, the better, apart from the due diligence rigours of the fund manager.
Equity has a higher risk-return profile than debt i.e. expected returns and potential volatility are higher. As long as you have allocation to equity in your portfolio, that component anyway carries an elevated risk-return profile than the relatively riskier part of debt investments.