Consider a client who approaches you, confused as to why his long-term Gilt fund dropped in value during a month when his corporate bond fund remained relatively stable. He assumes that because the Gilt fund holds government securities, it should be the safest and most consistent performer in his portfolio. This is a moment where you, as an MFD, must clarify the fundamental difference between credit risk—the risk of a borrower defaulting—and market risk—the risk that interest rate fluctuations will erode the value of existing bonds.
Credit risk is the probability that an issuer, such as a private corporate entity, will fail to pay interest or principal on time. Corporate bonds carry this risk, which is why they generally offer a higher yield or ‘spread’ over government securities to compensate the investor for the potential of default. When you recommend a credit risk fund, you are essentially helping your client earn this extra premium.
However, the client must be aware that if the credit quality of the underlying companies deteriorates, the Net Asset Value of the fund will likely see a sharp decline, regardless of what the broader economy is doing.
Conversely, market risk, specifically interest rate risk, impacts every bond fund but manifests most intensely in long-duration portfolios like Gilt funds. When the Reserve Bank of India increases policy rates to combat inflation, bond prices across the board fall; however, those with longer maturities are hit much harder. A Gilt fund has zero credit risk because the sovereign is unlikely to default, but it carries significant market risk.
Your role is to explain that a Gilt fund is not ‘risk-free’—it is only free from the risk of non-payment, not from the risk of volatility caused by the changing interest rate cycle.
In your practice, you must balance these two. A portfolio heavy on corporate bonds is vulnerable to a ‘credit event,’ such as a rating downgrade, while a portfolio heavy on long-term government bonds is vulnerable to a ‘rate event.’ By educating your client on why these risks behave differently, you justify the regular plan expense ratio by providing the behavioral coaching necessary to hold these funds through cycle changes. Providing this level of clarity transforms you from a processor of transactions into a strategic partner for the client’s financial stability.
Think of credit risk as the ’trustworthiness’ of the borrower and market risk as the ’environment’ in which the bond lives. If you manage the balance between these two, you steer your clients away from panic when market winds shift.
Nuance
Check Your Understanding
An investor holds a fund primarily invested in long-dated Government of India securities. If the Reserve Bank of India unexpectedly raises interest rates, which risk is most likely to cause a decline in the fund’s NAV?
A corporate bond fund experiences a sharp drop in NAV following a rating downgrade of one of its top holdings. What risk factor has primarily impacted the fund?
This is a companion read for Section 10.3 — Drivers of Returns and Risk in a Scheme from Ace the NISM Mutual Fund Distributors Exam by Akhilesh Gururani, available on Amazon Kindle.
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