Debt funds require deep insights

The year 2011 has been a mixed bag for mutual fund investors. While equity fund investors have been having a harrowing time as the stock market plunged by 28 per cent, the rising interest rate scenario has been good for investors of debt funds like liquid funds, ultra short-term debt funds and fixed maturity plans (FMPs). However, the RBI’s pause of rate hikes after 13 rate hikes in a row is likely to change the scenario. With inflation beginning to moderate, further rate hikes may not be warranted. In fact, clearly realising the risks to growth, the RBI has indicated a likely reversal in the cycle. If this materialises, the emerging interest rate scenario would warrant a few changes in the portfolio composition for debt fund investors. Here is how some of the debt fund categories are likely to perform going forward.

Fixed Maturity Plans (FMPs)
With bond yields closer to their peaks, FMPs remain an attractive investment option currently, as investors can lock in their money for various fixed maturities ranging from three months to three years. FMPs aim to generate predictable returns and at the same time, protect investors from interest rate volatility. While structurally, FMPs may be similar to fixed deposits, the tax efficiency of these schemes makes them a much better option. However, one must be quite sure about the time horizon, as the liquidity provided by these plans through listing on the stock exchanges is not very efficient, both in terms of the liquidity itself as well as the pricing.

Ultra Short-Term Debt Funds
The investment objective of these schemes is to generate reasonable returns and liquidity, primarily through investment in the money market and short-term debt instruments. Although these are potentially better than the liquid funds, the longer maturity of up to one year or so can result in slight volatility. If interest rates fall, the returns from these funds too will fall.
 
Short-Term Debt Funds
Short-term funds predominantly invest in debt instruments with one-two year maturity. These are potentially better than ultra short-term funds, but can be more volatile, as the ‘mark to market’ component in the portfolio is higher. However, when compared to medium-term debt funds and gilt funds, short-term debt funds experience lower interest rate volatility but offer attractive returns in a falling interest rate scenario. Therefore, investors with a time horizon of 6-12 months can invest in these funds and reap the benefits when the RBI begins to cut the rates.

Debt/Income Funds
Income funds invest primarily in debt and money markets with the twin objectives of optimum returns and liquidity for meeting investors’ medium term needs. These funds strive to earn steady returns by actively managing their portfolios on interest rate movements and credit risks. Since there is an inverse relationship between the interest rates and bond prices, these funds benefit from capital gains on bonds in a falling interest rate scenario. However, there is also the risk of a bond market rally not materialising in the manner being envisaged currently, due to higher government borrowings and a depreciating rupee. Therefore, it will not be prudent for risk-averse investors to invest in these funds just because everyone is talking about this emerging opportunity. Besides, investors must have a time horizon of 18-24 months for investing in these funds.

Gilt Funds
Gilt funds also provide a great opportunity to investors to benefit from rate cuts. Gilt securities are interest-bearing instruments issued by the government as a part of its borrowing programme. While gilt funds are ideally suited for those who are looking for safety as government securities carry zero default risk and are highly liquid, the downside is that the prices of government securities fluctuate sharply due to higher sensitivity towards the interest rate movement. As a result, gilt funds can be very volatile in the short term.

- Hemant Rustagi, CEO, Wiseinvest Advisors