A guide to debt fund

In the past six months, stock markets have risen by over 100 per cent. Even interest rates, which were at double digits last October, have slipped considerably.

However, with both consumer and wholesale price indices on the rise, there are indications that interest rates will not fall further. In its credit policy review later this month, the Reserve Bank of India (RBI) is expected to give signals to the return of a higher interest rate regime.

For investors in debt mutual funds, these are interesting times. They need to realise that their returns will be adversely impacted if rates go up. No wonder, experts are quite clear in their view - avoid medium and long-term funds. Also, gilt funds are a strict no-no. This is because they are the first to be impacted in case of a rate rise.

While there are various options for investors, they need to select the category that suits their risk-taking ability and time horizon.

Said Ramanathan K, head (fixed income), ING Investments, “Investors could look at short-term debt funds now because there is uncertainty about interest rates.”

The ultra short-term investor can park their funds in liquid funds for a few days or weeks. Liquid funds are offering 3-3.5 per cent returns. Then there are short-term funds (three to six months) offering returns of 5-6 per cent.

If one is ready to stay invested for a couple of years, one could look at dynamic funds. These funds are actively-managed debt funds. Fund managers buy and sell securities when yields are going up or coming down.

“For 2 to 3 years, income or dynamic debt funds are a good pick because they are expected to outperform inflation going forward,” said Arjun Parthasarathy, head (fixed income), IDFC Mutual Fund.

Some experts also said that fixed maturity plans (FMPs) and monthly income plans (MIPs) could be good options. Hitungshu Debnath, executive director, wealth management, Angel Broking, said, “FMPs and MIPs will help retail investors as they will lock into high interest rates and will give stable returns.”

Fund houses have already started launching FMPs aggressively. ICICI Prudential, Tata Mutual Fund and Fortis launched new fund offers recently. Market sources said that they were offering returns of 7-8 per cent.

Also, there are taxation benefits for FMPs. That is, an investor will get double indexation benefit on a scheme that is for more than a year. For instance, if you had invested in an FMP on February 2009 and it matures in April 2010, you will get the inflation indexation benefit for financial years 2008-09 and 2010-11.

MIPs are good for investors, who do not mind a little equity in their schemes. Typically, MIPs have 10-15 per cent of their money invested in equities. This improves their returns when the equity market is booming. At present, MIPs are offering returns of 10-15 per cent.

ING’s Ramanathan advised that investors should look for at least a two-three year horizon while investing in these products.