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Bonding with high returns

As interest rates come down, debt funds are poised to give attractive returns.

There is bad news if you want to invest in fixed deposits. Over the past few weeks, banks and financial institutions have cut their deposit rates by almost 2-3 percentage points. There are indications that the rates will soften further in the coming months. Clearly, the interest rate party is over.

For debt funds, however, it has just begun. The drop in interest rates has pushed up returns from debt funds, with the average income fund gaining 1.79% in the past one month. Experts believe that RBI will further cut interest rates in the coming months, which will benefit debt funds even more. "Over a oneyear horizon, debt funds should give attractive returns," says Krishnan Sitaraman, director, Crisil Fund Services.

Just as you inspect an equity fund's portfolio before investing, you also need to check the maturity and quality of holdings of a debt fund. Retail investors can find this information in the monthly factsheets and the prospectus-cumapplication forms of the funds.

"If the investor is willing to take additional risk for potential incremental returns, long-term debt funds is the answer. But if he does not want excessive volatility, shortterm debt funds are recommended," says Lakshmi Iyer, head of fixed income and product, Kotak AMC.

While funds that hold shortterm bonds aren't volatile, don't expect them to churn out the spectacular returns that some mediumand long-term funds have given in the past one year. Medium-term investors should choose funds that have an even mix of long-term and short-term securities. Long-term investors can opt for funds that hold bonds of very long-term maturity. But as Iyer warns, long-term funds tend to be more volatile. For instance, ICICI Prudential Income Fund has an average maturity of over 15 years. Note that its threemonth returns are in the red though its one-year performance has been very rewarding. It could give superior returns to investors over a threefour-year term.

It is important to keep an eye on the quality of the bonds in the fund's portfolio. Government securities, which carry no risk, are the most preferred, followed by AAArated bonds. Avoid funds that have a lot of AA-rated and A-rated corporate bonds. "Stick to funds that invest in the highest quality securities," advises Sitaraman. All the six funds chosen by us (see table) have very high quality holdings. For instance, our short-term pick, Kotak Floater Fund, has 92% of its corpus in highly safe bank deposits or AAA-rated corporate deposits. So, as far as credit risk is concerned, investors can rest assured that the fund is on solid ground.