The return of debt

Bond funds are relatively insulated from equity market vagaries. Money Today considers the benefits of debt.

Tanvi Varma/Money Today        Print Edition: March 6, 2008

Gaurav mashruwala, Certified financial planner

“Investors with an investment horizon of 2-3 years could look at longterm debt funds for additional debt allocation”
Dhirendra kumar, CEO, Value Research

“It looks like an opportune time to invest in long-term debt funds. Bond prices have already moved up in anticipation of interest rate cuts”

Would you invest in a debt fund that promised you returns of just under 10% or would you rather bet on riskier equities, which deliver average returns of 40%? Yes, this is a trick question. What if the equity market is extremely volatile? And what if there’s a macro-economic scenario of falling interest rates?

Add to this the uncertainties in global markets, which could have a domino effect on domestic markets, and you have a picture in which choosing a lowreturn instrument actually makes sense. Debt funds are largely unaffected by the equity markets (see graph). These funds provide steady, albeit low, growth over the long term, and funds that invest in longdated paper are also relatively insulated from vagaries in interest rates.

Mumbai-based financial planner Gaurav Mashruwala says, “In the current scenario, a mix of longterm floating rate and long-term debt funds is ideal for a debt portfolio, although the mix varies based on one’s investment objective.” Interest rates and bond prices share an inverse relationship— when rates rise, prices fall and vice versa. This affects the net asset value (NAV) of the funds, and thus has a direct impact on returns.

Top 3 funds

Floating rate income funds
Returns (%)
Kotak Floater Long Term
HSBC Floating Rate- LT
Tata Floater Fund
Gilt funds
 Birla Gilt Plus - Regular16.26
ICICI Pru Gilt Fund
Reliance GSF-LTP-Defined Maturity Date
Income funds
Birla Income Plus
Reliance Medium Term Fund
Birla Sun Life Income Fund
Liquid funds
HSBC Cash Fund
Templeton India Money Market Account
Lotus India Liquid Fund
Short-term funds
Reliance Short Term Fund
Templeton India Short Term Income
HDFC High Interest Fund
As on 4 February Source: NAVINDIA

Fluctuating interest rates do not affect funds if they only buy bonds that are held till maturity. However, fund managers tend to buy and sell existing bonds, and their funds are therefore affected by interest rate changes. While all this should not affect you—since the reason you invest in a bond fund is to let the fund manager worry about things like interest rate swings—it’s still good to know if your debt fund is performing as it should.

“With credit worries and a slowdown in the US economy, there is a renewed interest in the bonds and government securities markets,” says Ritesh Jain, head, fixed income, Kotak Mahindra Mutual Fund. Unless the markets tank over a prolonged period, equities will always get you higher returns; investing in debt funds is a good way to hedge the risk in your portfolio.

If you’re planning to give your portfolio some debt flavour, first consider your investment horizon. Fixed-income experts do not generally recommend holding a bond fund for a period of less than two years, and advocate investment in medium-to long-term funds. Liquid funds, generally money-market instruments, are ideal for investors with a very short time frame.

The yield on the 10-year government bond, the benchmark for long-term interest rates, fell by about 40-50 basis points in the past one month in anticipation of the credit policy announcement. With the US Federal Reserve cutting key interest rates by 1.25% within eight days, analysts believe that interest rates in India will follow suit.

“With key economic indicators in showing signs of moderation and an uncertain global economic outlook, the environment is conducive for interest rates to fall, which will benefit investors in longterm debt funds,” says Satyabrata Mohanty, fund manager, Birla Sun Life Income Fund. “Both domestic and global economic indicators indicate that interest rates have peaked,” he adds. However, this has not happened yet. “At the next policy meeting, we expect the RBI to lower the interest rates to be in line with the softer interest rates globally. Banks too have responded by lowering the interest rates in their lending programme,” says Jain.

The market is already following these cues, which is evident in the assets under management of bond funds, which have increased 200% since January last year. Some funds within this category, like Birla Sun Life Income Fund, have delivered annualised returns of 16%. “Our portfolio maturity was recently increased to 14.92 years, compared to the average 10 years maintained by other funds, since we were convinced on the downward trend in interest rates. This has worked well,” says Mohanty.

Other funds like Reliance Medium Term Fund have posted similar returns. During the same period, top-performing short-term fund, Reliance Short Term, delivered 14% returns, compared to an average 9% delivered by liquid and floating rate funds (see table above). “In future, investors can expect returns of about 7-7.5% in liquid funds, short-term could yield 8-9% and income funds will give 10-12%,” says Jain.

Further, unlike bank fixed deposits, debt funds fall outside the tax bracket you are in. You also pay only longterm capital gains tax of 10%, and need not worry about TDS. Although equity should continue to form the main part of your portfolio, it comes with much higher risk. Therefore, a mix of debt instruments is integral.

There is no rule of thumb for allocation in debt, but it could be 20-40% of your portfolio. “Fixed deposits may be suitable for an investor in a lower income bracket since otherwise the tax eats into the returns. Fixed maturity plans, with a rollover option, could be a good option for investors looking for a trade-off between liquidity and returns. Rolling over would provide the option to liquidate one’s money while it comes with a risk of reinvesting at lower interest rates,” says Mashruwala.


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