The last four years have not been a great time for income fund investors. Interest rates have been going up, which have resulted in lower returns from debt funds.
From an average return of 15.86 per cent in 2002, the return on the average medium term debt fund declined to 7.91 per cent the next year, and then to 0.93 per cent in 2004.
For the next two years, the average returns were just 4.89 per cent and 5.05 per cent. On the other hand, most other investments, especially equity funds have done very well.
The RBI, fearing inflation, has hiked the interest rates seven times in four years. This has resulted in fixed deposit rates going up. The NAVs of the debt schemes rise when the price of the fixed income securities go up. For that we need to understand the inverse relationship between the price and yield of a debt instrument.
Let us take an example. Say A invests Rs 1 lakh (Rs 100,000) in government bonds. The price is Rs 100 per bond and hence, he receives 1,000 bonds which earns 8 per cent a year.
The tenure is for six years. After six years, the government will pay him an interest of Rs 4,000 half yearly, and in the cumulative option, it works out to 8.16 per cent a year, after compounding.
Assuming that these bonds are listed and can be traded, if the government lowers the interest rates on similar tenure bonds to 6.5 per cent, then A benefits in two ways. One, he is locked at a higher interest of rate at 8 per cent. However the bigger advantage is that A can make a good profit by selling his bonds.
Since, the new bonds are being offered at 6.5 per cent, his earlier 8 per cent bonds which were priced at Rs 100 will now have to get aligned to the new rates. He can sell these bonds for Rs 107 and make a profit of Rs 7 per bond (Rs 107 is the price at which the bond will yield at 6.5 per cent)
Similarly, had the interest rate moved up and fresh bonds issued at 9 per cent the price of his bonds would have gone down to say, Rs 95.5, then he would be making a loss of Rs 4.5 per bond.
This has been happening to debt investors in the last few years due to rising interest rates the yields have been falling. Since the value of the bond falls, the NAV of debt funds decline, and yields lower returns to unitholders.
With the credit policy on Tuesday, you can be assured that all ears will be on the RBI governor's pronouncements. Says B Prasanna, senior vice president,ICICI Securities, "With inflation and credit growth slowing down considerably in the last few weeks, the RBI must be closer to pressing the pause button on interest rate hikes. However, the market has begun anticipating this development and yields are close to six month lows. Yields have the potential of falling further in the next three months if RBI decided to wait and takes stock. "
He adds, "However, whether we have seen the top in the current interest rate cycle can be ascertained only, if credit growth, money supply and inflation continue to show a declining trend in the next few fortnights. Meanwhile we can expect RBI to continue with liquidity suction measures through market stabilisation scheme/cash reserve ratio."
That could mean a good time to enter debt-based schemes. Here are a few options:
Fixed maturity plans (FMPs): They are placed on the lowest rung because their returns are more or less indicated. As yields are falling, so will the returns from these schemes.
Cash/liquid schemes: These schemes are used for temporary parking of surplus funds. They carry no entry or exit loads but there is a high dividend distribution tax (DDT) for individuals and HUFs at 28.33 per cent. For non cash/liquid schemes, the DDT is 14.16 per cent.
Liquid plus plans: If the finance minister decided to tax liquid plans, fund houses have an answer in liquid plus plans, which invest in papers of higher maturity. However, these may have an exit load, if investment is for 7 days or less but lower DDT.
Short term plans: These products invest in securities of fixed maturities for three months to six months. If there is a movement in interest rates, the relative volatility will be lower. A variant of these are the short term floater schemes.
Medium-term income plans: Invest in instruments which are of higher maturity greater than one year and are therefore, more volatile. A variant is a long term floater.
Gilt funds: They invest in sovereign bonds. These are, by far, most sensitive to interest rate movements and thereby the most volatile, as well. They see the greatest upside, if the sentiment is bullish (interest rates moving down) and downside (if interest rates move up) as well.
Dynamic bond funds: They work like flexi-cap schemes of equity funds, where the fund manager has the liberty to invest across the maturity spectrum, wherever they see an opportunity to register gains.
Depending on your risk appetite you can take a call and enter into these schemes. After the credit policy, if the view on interest rates is positive, look at long term income schemes as well as gilt schemes.
A good tip is to invest in schemes with large asset management companies because they will be the ones who will register highest portfolio gains.
Dynamic bond funds will also be a good bet if you want your fund manager to take your call on your behalf. We may be in for a bull run in debt schemes for the next six months, so catch it.
The writer is head, mutual funds, Derivium Capital & Securities. The views expressed here are personal.
