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.
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