Good time to invest in Debt funds

When equity markets are giving sizzling returns, we tend to forget about asset allocation and join the herd in maximising returns by aggressively tilting our portfolios towards equities. It’s only when equities land with a thud, like it has done in 2008 (the Sensex has dropped 60 per cent from its highest closing on 8 January, to its lowest closing on 20 November), that we flock towards alternate asset classes. Asset allocation is about striking a balance according to your needs and risk profile, across all asset classes. One important asset class that was long forgotten has staged a quiet comeback. It’s safer and less volatile, and merits attention in 2009. Reintroducing the humble debt fund.

Low interest rates
Debt funds and interest rates are inversely proportional. When interest rates fall, net asset values (NAV) of debt funds rise, and vice versa. India, as in the rest of the world, is witnessing drastic rate cuts. The global credit crisis has slowed down economies across the globe. India’s industrial production recorded a negative growth of -0.4 per cent in the month of October, as against a positive growth of 12.2 per cent the same time last year. Due to an unprecedented decline in domestic and foreign demand, industrial productivity has dipped for the first time in more than 13 years.

The ensuing liquidity crunch has hit us hard and the banking system has been starved of cash. Already banks have been finding it difficult to lend money and are also facing the threats of defaults. Companies are expected to deliver poorer results because of fall in demand for goods and services. Added to that are the revised growth projection of 7.5 per cent for India, down from 8 per cent earlier. India, like many other economies, is facing a slowdown, if not a recession.

As a move towards boosting economic activity and ensuring liquidity, central banks all over the world have been cutting interest rates. Says Laxmi Iyer, head, fixed income, Kotak MF: “Interest rate cuts have now become a worldwide phenomenon so that economies do not go into recession. Interest rates are cut to spur growth in the economy, to make funds available at cheaper costs to facilitate low-cost borrowing and increased production activity.”

In India too, the Reserve Bank of India has cut its key rates repeatedly between October and the first week of December and made over Rs 3,00,000 crore available to the banking system. The benchmark interest rates were again reduced on 6 December 2008 as part of the government’s economy stimulus package as a signal of a benign interest rates regime.

Drop in inflation
Another reason why interest rates in India are headed south is a drop in inflation. From a high of 12.91 per cent in August, inflation has fallen to 8.90 per cent, as on 8 November, due to a fall in oil and commodity prices. typically, when inflation is high, interest rates are kept at a higher level to keep the real rate of return (interest rate earned after deducting inflation) high.

Says Ritesh Jain, head, fixed income, Canara Robeco MF: “Inflation is expected to come down to around 4-5 per cent levels around March 2009 and to near-zero levels in June 2009. If inflation is low, the government’s monetary policy will be in your favour as, in India, monetary policy follows inflation.” In short, in India, low inflation indicates low interest rates.

Reduction in Spread
Typically, bond funds invest in two kinds of instruments, government securities and corporate bonds. A debt fund’s NAV largely depends on which of the two segments it has invested in and in what proportion. When interest rates fall in these segments, bond funds’ NAVs appreciate. Although interest rates on debt scrips have come down, rates of
government securities have fallen more than those of corporate bonds.

For instance, the benchmark 10-year government security rate has fallen to 6.79 per cent as on 3 December, from 9.47 per cent on 15 July, a reduction of 269 basis points. In comparison, interest rates of a similar AAA-rated corporate paper haven’t dropped as significantly. The difference in the interest rates, called spread, between the two kinds of papers has in
fact widened to around 396 basis points in November, up from around 138 points in July.

Says Nandkumar Surti, chief investment officer, fixed income, JP Morgan MF: “This spread will have to narrow down as interest rates are on their way down. Interest rates of corporate bonds will, therefore, have to come down too.” When spreads reduce, bond funds will benefit more than gilt funds.

Debt funds
We suggest you consider long-term gilt funds and long-term bond funds. While gilt funds will solely invest in government securities, bond funds would invest across all debt asset classes such as government securities, corporate
bonds or certificates of deposit.





Asset allocation. “Invest around 50 per cent of your corpus in gilt funds and the rest in bond funds,” says Iyer. Note that while government securities are safer than corporate bonds since the former comes with a government guarantee, they could also be more volatile as they are the most liquid of all debt scrips and, hence, change more hands. However, Surti recommends a tilt towards bond funds as he believes the spread compression, when it happens, will result in bond funds outperforming gilt funds. By one estimate, well-performing debt funds are expected to give 15-20 per cent returns in 2009.

Some of the fund houses listed in Outlook Money recommendations (‘Strongest Bond Funds’ and ‘The Brightest’) have both bond and gilt funds. Although both kinds of schemes from all these MFs are worth investing in, we suggest you diversify across fund houses.

Duration. Look at long-term debt funds with a time horizon of one year. Avoid them if your limit is less than six months. Go for liquid funds if you want temporary parking space for your funds. Or, you could go for short-term bond funds if you are willing to take the risk, for tenures of not more than three to six months.

Watch out for...
...Credit quality. While government securities are guaranteed by the government, a bond fund’s portfolio carries credit risk. The more your fund’s assets are in higher-rated securities (AAA-rated and equivalent, including government securities), the better it is, for two reasons. One, fund insiders say that the default risk that plagued the fixed maturity plans (FMPs) not so
long back, is still around. A bond fund that takes on too much credit risk might put your principal amount at risk. Two, higher rated securities are also more liquid and can be easily sold by your debt funds.

...Maturity. As long-term funds will benefit more than the short-term funds going ahead, look at your fund’s average maturity. Avoid funds with a lower maturity.