How income funds counter the risk of surges in interest rates?

When interest rates go up, there is a fall in the prices of existing bonds held by debt funds. Hence, the NAVs of debt funds come down.

     Print Edition: February, 2010

Your story on safe, yet high-yielding, financial products (How to Invest Without Fear, January 2010) has an interesting premise. Many people want products that beat inflation without the risk of wiping out the invested capital. However, I do not understand why income funds fall in this category. How do they counter the risk of surges in interest rates by including funds with wide-ranging maturity periods? Please clarify.
-Vineeta Shah, Mumbai

When interest rates go up, there is a fall in the prices of existing bonds held by debt funds. Hence, the NAVs of debt funds come down. The prices of long-term bonds are more vulnerable to a firming up of interest rates compared with short-term bonds. So, during a period of rising interest rates if a debt fund reduces its portfolio maturity (that is, moves to bonds with short maturity periods of, say, one to three years, depending on the movement in rates), the fund's NAV would be less likely to drop.

Your latest cover story (What Lies Ahead? January 2010) states that stock valuations at the current level are close to historical highs and that it will be very difficult to identify cheap stocks. According to the story, only a rise in corporate earnings can increase stock prices this year. How can small investors with limited access to information avoid expensive stocks while exploiting the buoyancy in the markets? Which category of stocks should they focus on?
-Prateek Raina, Kochi

As you have rightly interpreted, 2010 is going to be a difficult year to live up to expectations, especially after the over 80 per cent returns generated by the benchmark indices (BSE 500) last year. Analysts believe that if most of the positive cues are priced in, the opportunity for wealth creation will come from small- and midcap stocks. While there is limited information available on this genre, we will try to regularly identify the opportunities in this space. Meanwhile, conduct a background check with your broker's research team after zeroing in on a particular company. A thorough probe on valuations and future prospects is also a must. You can participate in the market through well-established equity funds too.

Keeping tabs on foreign institutional investors (FIIs) is a good idea, but it is not practical for small investors (Copy the Big Daddies, January 2010). FII movement can be tracked through the quarterly results of the company they have invested in, but this would be a little late for the investor. In the time lag of three months, the stock prices and, hence, their valuations could change significantly.
-Dev Chattopadhyay, Kolkata

The FIIs have access to valuable company information that is unavailable to retail investors. Their investment pattern needs to be analysed over a long period, say over four to five quarters. If they show a consistently rising interest in a company, it is a sure indication that it has sound fundamentals. The lag effect is immaterial for medium- and long-term investors because they are not looking to book returns in three to four months.

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