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When debt funds can be risky

January 22, 2010

Rule: Investments in debt funds are safe because they do not have exposure to volatile assets such as equity shares.

Exception: When interest rates are rising, long-term debt funds can give negative returns. This is because the value of long-term bonds with low interest rates goes down in the secondary bond market when rates rise.

-4.2 per cent has been the return from the longterm gilt fund category in the past one year ending 21 December 2009. The worst performing fund lost over 11 per cent during this period.

6.9 per cent has been the return from the floating rate long-term category in the past one year ending 21 December 2009. The best performing fund earned 7.7 per cent in this period.

Long-term bond funds did very well in 2008, with the category delivering an astonishing return of 25.33 per cent during the year. But in 2009, rising interest rates caused bond prices to slide. The funds holding bonds of long maturities suffered losses, with the average fund losing 7.26 per cent.

Returns from debt fund categories

The average maturity of the securities held by a debt fund is crucial. Funds with long-term bonds (10-15 years) are very sensitive to interest rate changes. As the table above shows, even medium-term debt funds (average maturity of 3-4 years) didn't do well in 2009, while the short-term category (average maturity of less than one year) remained largely unaffected.

Apart from the long-, medium-and short-term debt funds, there are floating term debt funds. These invest in bonds where the coupon rate is not fixed but is linked to a benchmark interest rate. This renders them immune to rate changes and ensures consistent (but not very high) returns for investors.

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