Be Partial To Debt Funds

Globally, most major economies are in recession or close to recession. The Indian economy too has been impacted by this global slowdown. To tackle this extraordinary situation, central banks world over have been resorting to rate cuts. In India too, the RBI has cut CRR by 3.5 per cent and repo rate by 2.0 per cent in a short span of time. Clearly, the intention of the RBI and the government is to ease the liquidity crunch and support economic growth by reducing rates. Taking a cue from this, banks have also started cutting the prime lending rates (PLR). Besides, oil prices have crashed from their peak levels to three-year lows and are expected to go down further. Other commodity prices like metals are also down from their earlier highs.

This has helped a great deal in bringing the inflation down to 6.61 per cent after almost five months of double-digit inflation. It will not be wrong to say that the focus has shifted from inflation containment to economic growth. Therefore, one can expect more rate cuts in the future to further stimulate the economic growth curve.

The current scenario, wherein the interest rates are on a decline, is favourable for gilt as well as medium-term debt funds. Debt and debt-related funds like liquid plus, FMPs, short term as well as medium term debt funds can play an important role in the asset allocation process and every portfolio must have them in a varying proportion depending on one’s risk profile, time horizon and investment objectives. These funds provide stability to the portfolio and also enable rebalancing of the portfolio from time to time. Over the last one year or so, the focus has been on FMPs. The higher and tax efficient returns offered by these plans have made them very popular among the investing public.

However, considering the revised regulations that have banned premature withdrawals in the closed-ended funds as well as the lower indicative yields have made them unattractive for investors. FMPs are offering indicative yields of 8 per cent as against 12 per cent offered a couple of months ago. It’s time for investors to revisit their strategy for the debt portion of their portfolios. The focus has to be on gilt and medium term debt funds. Before we proceed, let us understand what these funds are and what they offer. Gilt funds, as the name suggests, invest in medium and long term government securities. These funds allow investors to invest in the otherwise wholesale government securities market and seek to generate risk-free returns.[PAGE BREAK]

These funds also benefit from trading profits as the demand supply gap and market imperfections provide many trading opportunities to the fund managers. Besides, in a falling interest rate scenario, the fund manager can maintain a longer maturity profile to maximize the gains. Debt funds invest in medium to long-term debt instruments issued by private corporations, financial institutions, banks and government.

These funds can be described as low risk profile funds that generate regular and predictable income for investors. Though there are low risk funds, investors in these funds are still subject to liquidity, interest rate and credit risks. Coming back to the changing interest rate scenario, the yields for debt instruments have started falling in response to the RBI monetary actions. When the yields start falling, the bond prices begin to rally. In other words, in a falling interest rate scenario, older debt securities go at a premium as they offer higher coupon rate compared to the rate offered by new debt securities.

It is important to know that interest rates and bond prices have an inverse relationship. When the interest rates fall, the market adjusts bond prices to increase the interest rate yields, i.e. their prices rise. As a result, debt funds holding these bonds tend to give better returns by way of an increase in the NAVs.

Though gilt funds will continue to do well, debt funds have the potential to outperform them. However, the right way for investors to benefit from the emerging scenario would be to invest both in gilt as well as debt funds. However, while allocating the funds, the bias should be towards the debt funds.