Over to debt funds?

For some time now, Sandeep Bhalla (name changed), 35, an executive at a foreign bank, has been shifting his investments from a mere savings account to fixed income funds as the yields have turned attractive. He recently invested in a one-month fixed maturity plan (FMP) at an indicative yield of 8.5 per cent per annum. Says Bhalla: "I have invested my liquid cash in a monthly FMP that gives me higher interest rate than savings banks as well as the option of re-investment at zero entry and exit load."

For the conservative fixed income investor, there has never been a better time to invest in the debt instruments. Yields are rising, and investors are increasingly warming up to debt these days. Though returns from debt funds aren't extraordinary as compared to, say, equities, they have increased by about 100-200 basis points in the last year. Average returns from debt funds were around 7.31 per cent last year. Indicative yields on FMPs lately is around 8-9 per cent, a shade higher than debt funds. Yet, not all debt funds make investment sense.

Inside the debt fund

Interest rates have an inverse relationship on the price of debt securities

If the rates rise, their prices fall to adjust for the current yield, and vice versa

If a fund holds a large portfolio with securities of longer maturities, the impact on NAV is usually negative when rates rise, and vice versa

As interest rates harden, short-term debt funds have the least impact on NAV

At this point, it's better to invest in fixed maturity plans or liquid funds

Rising rates don't impact all debt funds in the same manner. Debt funds, due to the composition of their holdings, may either see an increase or decrease in their NAV (net asset value), if the rates rise. If a debt fund has invested in long-dated securities, rising interest rates reduce the price of securities and therefore impact the NAV negatively. A floating rate fund, on the other hand, can re-price its yields according to the market conditions, which will benefit the NAV.

So, go selective while investing in debt funds. Market watchers opine that the interest rate seems to be peaking out. Says Nilesh Shah, CIO, Prudential ICICI AMC: "Irrespective of the equity movement, one should always hold debt from an appropriate asset allocation. Unlike the past four-to-five years, the equity market is not expected to match its impressive return. Interest rate is expected to peak and debt funds are expected to show signs of revival, thus giving opportunity for investors to make money in both class of assets."

But debt has options

Maximising yields on debt revolves around choosing funds carefully. FMPs score here. They have a fixed tenure and the yields are higher than a regular debt fund. Says Dheeraj Singh, an independent consultant: "Currently, an FMP is the best bet an investor can get into. Apart from robust returns, the paper has low risk." Over the long term, FMPs also score because of their tax advantage. "Investors should invest in long-term FMPs with maturity of 12-18 months," says Shah.

But if you are looking for a short-term investment, it's best to opt for short-term FMPs and liquid funds. Says Singh: "The uncertainty over rate hike still persists and if the interest rates see a massive move up, staying invested in short-term FMP and liquid will give the investor the added advantage over long-term FMP." Short-term floating rate funds are also an excellent option in case you have idle funds lying in your savings account. Over the past one year ended June 13, 2007, average returns from short-term floating funds were 7.14 per cent, compared to 6.98 per cent of long-term floating funds.

Experts don't see any reason for investing in regular bond funds. "From the current levels, there aren't any signs of a massive blip in the interest rates and there is no incentive to invest in regular bond funds, at the short-term or the long-term," says Singh. "However, if interest rates see a massive surge and not expected to sustain at those levels, short-term funds would be an attractive option for investment." In the past one year, the average returns recorded by short-term debt funds have been 6.96 per cent.

When interest rates start to decline, regular bond funds will benefit and investors will make double-digit returns from the rising prices of underlying debt securities. But for now, it's best to park money in FMPs, liquid funds and short-term funds.