Debt Funds

Investing in debt funds.

While you were sleeping…
… The debt fund pillow flattened out.

Financial advisers have ridden on this mantra for long - equities are for the daredevils and debt for the ultra safe guys.

All that was required of you was to figure out what kind of a person you were and invest accordingly. But the last three years have been an exception to the rules of the game. While equity investors plumbed a deep through, the risk-averse guys, who blindly put their money in debt funds, have been sleeping soundly, knowing that their funds are not only safe, but are also growing rapidly.

Bond funds have had an excellent run indeed. The reasons are simple: when interest rates fall, existing bonds that carry higher interest rates become more attractive. Their prices rise. It is this rise in bond prices that has driven the bond fund rally for the past few years while equity market was suffering from the effects of an ailing economy and wary sentiment.

But for those who continue to invest blindly in bonds, it may be time to open their eyes. With the hope of an economic revival round the corner, demand for funds is likely to go up. Banks will revert funds to industry and reduce their exposure to the debt markets. Debt funds will no longer be the unexpected jackpot they turned out to be. If interest rates move up, an existing portfolio could see its value deplete. Freshly-issued bonds will carry a higher coupon and will obviously be more sought after than the older bonds.

Not everyone seems to think there's reason to be upset. Mutual funds have been quick to realise how interest rate volatility will hit their returns and erode the value of their portfolio. Many have introduced variations to their plain vanilla debt schemes. Dynamic bond funds and floating rate funds are tow such variations. But even these may have their limitations.

Dynamic bond funds are different from regular income funds in the way they invest. While an income fund balances the proportion of corporate bonds and gilts and their maturity in its portfolio, a dynamic bond fund attempts extreme moves. If the fund manager expects the gilts and their maturity in its portfolio, a dynamic bond fund attempts extreme moves. If the fund manager expects the gilt prices to rally sharply he will invest the entire corpus in gilts. If he expects interest rates to rise, he will divert the cash into short-maturity instruments, which are least affected by interest rate fluctuations.

If interest rates don't fall drastically in the future, the task of a dynamic bond fund manager will become more challenging there is limited scope for capital appreciation. The fund manager will be under constant pressure to deliver returns associated with the fund's dynamic style of management. These funds may offer some recourse from interest rate fluctuations. But their performance over the last year shows that in a rising interest rate era, they have under performed the average medium term bond fund. But when interest rates have fallen, they have done somewhat better.

Floating rate funds are another variation. A normal bond's price changes with the interest rate. In floating rate papers, the interest rate is adjusted periodically. So floating rate bonds are less volatile and can be used as a hedge in times of rising interest rats. When interest rates move up, a floating rate fund will be the only income fund that protects returns-as its coupon will be set to higher levels.

A long term floating rate fund and a short-term debt fund both have similar portfolio maturity. According to fund managers, the main reason for this is the absence of sufficient long term floating rate instruments. If interest rate fluctuations are your biggest worry, a floating rate fund is the solution.

Despite the impending fate of debt funds, they are still an important investment in your portfolio. As long as investors put their money in with a long-term view, debt fund should continue to be an important part of their portfolio.

Be prepared for rising interest rates and brace yourself for dipping returns. In fact, investing in debt for the short term can actually make you lose money. Even as you read this, mutual funds are probably scratching their heads to come up with newer ways to attract and keep you in the debt market. Just remember to walk in with your eyes open; realty can bite.