Debt Funds: The dawn of a new era

Year 2003 saw the fixed income investor coming to grips with the dreaded word -- volatility.

This, and a sustained fall in interest rates in line with the Reserve Bank of India's stated objective of pursuing a soft interest rate regime were the highlights of the year.

Of course, this translated into lower returns for the debt fund investor with a single digit growth becoming a reality.

To begin with Year 2003 greeted the relatively 'peaceful and benign' debt fund investing community with a prolonged bout of volatility.

Bond yields rose sharply, which lead to a fall in debt fund NAVs. A lot of investors switched to liquid funds and short term plans while a lot more were left contemplating the future of debt funds and if it was worth remaining invested in them.

There was more bad news for the debt fund investor when the Monetary Policy was announced April 2003.

While the RBI's decision to cut CRR and bank rate by 25 basis points (bps) did serve to lower the cost of borrowing for the industry, it also signaled a further decline in returns for debt fund investors.

As Nilesh Shah, CIO,Debt Franklin Templeton Investments, puts it, "The days of double-digit returns in debt funds are over."

Investors were just about recovering from the spate of bad news when debt markets were hit by more volatility. It was enough for us to visit leading debt fund managers to get their take on the debt markets and what was in store for the debt fund investors. The answer we got was loud and clear -- volatility in debt markets is here to stay.

Getting used to single-digit growth…

A common thread running across the leading debt funds was their 'dynamic' trait. This is a relatively new segment within the debt fund category that allows the fund manager to switch liberally between corporate bonds and government securities without any cap on either. Of the five leaders as many as three (PruICICI Flexi Income, Sundaram Select Debt, Grindlays Dynamic Bond) belonged to this category.

It was in October when talks of rate cuts in the upcoming Monetary Policy led to a sharp and unprecedented fall in bond yields.

The build-up reached a stage when the 10-year G-sec yield fell to 4.90 levels. When the Monetary Policy was announced in November, it maintained a status quo on interest rates. This resulted in a sharp reaction in debt markets and bond yields started climbing to pre-Monetary Policy levels.

The surge in bond yields led to more losses for debt fund investors (remember a rise in bond yields implies a fall in bond prices which pulls down NAVs).

Those, in many ways, were the defining moments of Year 2003, for the debt fund investor -- sustained volatility that saw alternative bouts of rise and fall in NAVs.

MIPs: Doing the rescue act

Two factors brought MIPs to the fore:

• Debt markets were coming off their highs and investors were just not satisfied with single digit returns.
• Equity markets were witnessing one of their sharpest rallies ever.

If you add the two together, you get a product with a pre-dominant debt component and a little bit of equity to boost returns and offset the impact of falling bond yields. MIPs did the trick and caught the investor's eye.

The only problem was there weren't enough MIPs or to put it differently not all asset management companies had an MIP in their portfolios. So there was a tearing hurry to launch MIPs and investors (retail as well as corporates) took to it in large numbers.

A prescription to beat single-digit growth?

The difference between returns of debt funds and MIPs is palpable. The latter scored significantly across time frames.

While debt funds were hit by excessive volatility in the markets, MIPs made the most of a 'booming' equity market.

The aggressive MIPs (Alliance MIP, FT MIP) obviously did better with a harder equity push.

What to expect?

The run up in debt fund NAVs is clearly a thing of the past. As Nilesh Shah puts it, "We do not expect interest rates to move down sharply from current levels and hence investors need to tone down their expectations from income funds."

With the yield on 10-year government paper hovering around 5.15 levels, this is what debt fund investors can expect on the conservative side.

If you are fortunate, the fund manager may clock marginal growth in trading gains from fluctuating yields.

But that would be providential and its not something you can count on. Shah forecasts: "Going ahead, coupon income (and not trading gains) will play a bigger role in the returns of debt funds."

Another feature debt funds have come to acquire over the last 12 months is volatility. And going forward, volatility looks set to become something of permanent trait with debt funds.

As the short- to medium-term view on interest rates is still not very clear, volatility cannot be ruled out even at these levels.

One way to tackle volatility in long-term debt funds is by investing a portion of your assets in floating rate income funds. Shah advises: "It (floating rate funds) is ideally suitable for people who wants stable rate of return without any volatility. This fund could also be an ideal investment option especially in a rising interest rate scenario."

With debt fund returns sustaining only on the coupon rate, the gap between debt fund returns and fixed deposits has narrowed down considerably.

However, if one were to consider liquidity and tax-efficiency (for investors in the higher brackets), debt funds score over comparable investment avenues like fixed deposits, bonds and government saving schemes.

Of course, investors who are terribly disappointed with debt fund performances may want to consider taking on some risk and investing in MIPs.

All MIPs have a ceiling on the equity component, which they adhere to very consistently. There are some MIPs that have an equity cap of only 10 per cent, which should suit most investors.

What this will serve to do is it will enable MIPs to outperform debt funds marginally in the worst of times and significantly in the best of times.

That anyway is the mantra going forward -- expect more return but take on more risk to get there.

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