Debt funds have some obvious advantages: they offer high liquidity and are more tax-efficient than fixed deposits. When interest rates are coming down, bond funds give better returns than fixed deposits.
This is what happened in 2008, when the interest rates were cut as part of the stimulus package. The long-term bond funds category delivered an astonishing return of 25 per cent during this year. Fixed deposit returns seemed puny in comparison.
|"For the risk-averse investors, it is better to stick to short-term bond funds in the current scenario. They can also go for closed-ended fixed maturity plans."|
Head, Fixed Income, Taurus Mutual Fund
However, when it comes to the safety of capital, fixed deposits score over debt funds. In the disclaimer- mutual fund investments are subject to market risks-the reference is not to equity funds alone.
You can lose money even in a debt fund. This came true in 2009, when rising interest rates caused the bond prices to slide.
The funds holding bonds of long-term maturities suffered losses, with the average long-term fund losing 7.26 per cent. This year has been a little better, with the average long-term bond fund giving a return of 3.4 per cent-less than what your money would earn in a savings banks account.
In the current context of rising interest rates, almost all categories of debt funds have delivered abysmal returns (see table)
With inflation showing no signs of abating and the RBI not in a mood to ease monetary tightening, this poor showing by funds holding bonds of long-term maturities will continue for some time.
Income funds are increasingly replacing longterm bonds with short-term papers in their portfolios, which has brought down the average maturity of their holdings.
Investors can also avoid getting caught on the wrong foot by opting for floating rate funds, which invest in instruments with a floating interest rate. These are less sensitive to interest rate changes.
"For the risk-averse investors, it is better to stick to the funds holding short-term bonds in the current scenario. They should also consider closedended fixed maturity plans (FMPs)," says Rahul Pal, head of fixed income, Taurus Mutual Fund.
FMPs are another way to tide over the volatility in interest rates. These plans hold their bonds till maturity, so there is no possibility of a loss. However, FMPs still carry the default risk.
They can also opt for fixed deposits. Fund-starved corporates are offering very attractive interest rates on 1-3 year deposits, but remember that they are not as tax-efficient as debt funds.