In debt investment, your fund manager, or the fintech through whom you are investing, lend the money to different companies. These investments earn interest. The interest and principal are payable as per a predefined timeline. Hence, the quality of the institution to whom the money is lent has a crucial role to play.

Credit risk is high when the possibility of the borrower defaulting on payment of interest or repayment of principal on the predefined day is high. The better the company from a fundamental and quality perspective, the lower the chances of issues with those investments. Well-established companies, or companies with a solid track record, usually offer lower rates compared to the companies that are at the growth stage. The non-payment of interest or principal directly affects investors and hence this credit risk is an important factor to consider at the time of investment.

The interest rate and price of the bond are inversely related, whenever the interest rate increases the price of the bond reduces and vice-versa. The interest rate in India keeps fluctuating based on many factors like demand and supply of money, inflation, government borrowings, etc. The impact on the overall portfolio due to a change in interest rate is what interest rate risk is all about. For example, you hold debt instruments with a long-term maturity at an interest rate of 7% per annum and if the interest rate goes up to 8%, the value of your instrument will go down as the investment needs to generate interest that matches with the revised interest rate of 8%. The longer the duration of the bond, higher the interest rate risk.

Many new companies or startups offer higher rates and raise investment through the fintech platforms. These fintech platforms also do their due diligence before listing those companies on their platform. In debt funds, the first thing any fund manager will look for is to reduce the risk as investors’ prime reason for investing in a debt instrument is to take less risk. Based on different kinds of objectives, the funds will invest in different companies and institutions to diversify the investment.

The bond baskets offered by fintechs have the potential to generate higher returns but may carry additional risk. A debt fund is more diversified and invests in established institutions. Debt funds also consider the interest rate cycle as it has its impact on the price of the underlying asset which is the bond, this may not necessarily be the objective of the basket offered by fintechs.

Harshad Chetanwala is co-founder, MyWealthGrowth.

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Updated: 06 Nov 2023, 10:27 PM IST