FUND FLAVOUR
December 2010

A perfect fit…

Are you looking for debt instruments beyond bank fixed deposits and post office instruments? Debt mutual funds may fit the bill well. Debt mutual fund is a product whose main aim is capital preservation coupled with descent returns i.e. higher than savings account and bank fixed deposits. Debt fund returns is essentially a combination of capital appreciation and regular income. Capital appreciation is where a debt mutual fund has an edge over a fixed deposit. Capital appreciation is possible because the debt instruments that the mutual fund company invests in are tradable. Based on the interest rate, the bond yields move. When interest rates move southwards, yields on bonds increase making it profitable for mutual fund companies to sell the bond.

Fund Flavour analyses threadbare the performance of the entire gamut of debut mutual funds in the past one year.

Gilt Funds
Lacklustre…

Gilt Funds invest in government debt, namely, the debt issued by Reserve Bank of India on behalf of the government. They also invest in securities issued by state governments. The investments are done in ultra safe paper because they are backed by the government itself but that does not mean the Gilt Funds are risk free. They can go down in value because when interest rates rise, the value of the debt goes down. So, there could be a possibility that the debt funds lose some part of their NAV also. Short government funds invest in government securities with one- to three-year maturities. For one-year period, the category delivered marginal 2.2% return. The intermediate government bond category includes funds with residual maturities between three- to seven-years and generated 0.4% returns. Out of 11 funds shortlisted for analysis, three funds beat their category peers. Long government funds invest in government securities with average maturities of more than seven years. This category generated -0.1% return during the one-year period. Out of 8 funds selected for analysis, only three funds outperformed their peers. Gilt Fund returns have suffered a substantial slowdown over the past one year. Gilt funds, which lost their lustre due to hardening yields on government bonds, are slowly moving up the performance charts on the back of an increase in bond prices in recent months. The average return delivered by the 47 funds was 2.9% as against 11.5% a year ago. Of the 47 medium and long-term gilt funds, only 20 funds beat the I-Sec Composite Gilt index's returns of 2.9% while six funds delivered negative returns. In this scenario, gilt funds have witnessed a muted performance.

Fixed Maturity Plans
Towering over FDs…

Fixed Maturity Plans (FMPs) are quite similar to fixed deposits in the sense that these funds are usually closed ended, which saves you from interest rate risk, and even if rates move upwards the fund NAV does not go down. The way the fund works is that a fund house announces a new fund offer specifying the duration of the fund say 18 months or so, and then they collect money from you which is then invested in debt of the same duration. These funds have become popular because of a sort of a tax advantage where interest on fixed deposits is charged at a higher tax rate than dividends from FMPs for individuals who are in the higher tax bracket. The risk of investing in FMPs is that they might invest the money in lower quality debt, and then during times such as the last crisis might come under pressure, and in that sense your capital is not really assured as it is in the case of a fixed deposit. Most of the corporates prefer investing in fixed maturity plans, offered by mutual fund houses as these provide maturity at shorter terms while offering competitive profits. FMPs allow you to lock into prevailing market rates for debt via a professional manager. That is a unique benefit when other debt options such as bank deposits or small savings schemes do not dynamically adjust to market rates. One year FMPs have returned a minimum of 7% and a maximum of 14% over the past one year whereas one-year FDs have returned a maximum of nearly 7% only during the same time period.

Income Funds
The interest rate yo-yo…

Income funds are categorized on the basis of maturity period of the fixed-income instruments they invest in. The ultra short bond category with funds consisting of average maturities over 91 days but less than one year, posted 4.6% return in the past one year. Out of 21 funds analysed, 10 funds beat the category average. During the one-year period, the short-term bond category with residual maturities between one- to three-years, posted 6.1% return. Out of 15 funds considered, 8 funds outperformed their peers. The intermediate bond category, including funds with maturities between three and seven years, registered 4.5% return during the past one-year. Out of 20 funds shortlisted, 13 funds beat the category average.

Floating rate funds
An ace up the sleeve

A floating rate fund is a fund that by its investments in floating rate instruments seeks to provide stable returns with low level of interest rate risk and volatility.These debt securities peg their coupon or interest rate payable to a market-driven rate such as the Mumbai Interbank Offered Rate (Mibor). Hence, each time the benchmark rate fluctuates, the coupon rate is adjusted accordingly. The primary advantage of these funds is that they are less volatile than other types of debt funds. This advantage arises due to the inherent structure of the floating rate bonds. In case of fixed rate bonds when interest rates in the economy change, the price of the bond adjusts to make up for the fixed coupon of the bond. While this happens even in the case of floating rate bonds, the change in the price of the bond is less drastic due to the periodic change in the coupon of the bond. The fall in the price of the floating rate bond will depend upon the reset period. The lesser the gap between the resets, the lower will be the fall in price. The reset could be daily, monthly, quarterly, half-yearly, annually or any other periodicity specified by the issuer. These funds, in turn, ensure that the portfolio has a limited interest rate risk. Under normal conditions, floating rate funds intend to invest minimum 65% of net assets in floating rate securities. There are two types of floating rate funds — long term and short term. The portfolio of the short-term plan is normally skewed towards short-term maturities with higher liquidity, and the portfolio of the long-term plan is skewed towards longer-term maturities. However, even the longer-term funds are positioned more on the lines of short-term funds and are not very aggressive. Moreover, the volatility arising due to investment into long-dated fixed coupon bearing securities is offset by the presence of floating rate securities. The one-year return for the floating rate funds in the last one year was in the 5.3 to 6.1% range, and the 3-year returns range between 6.9% and 7.9%.

Liquid Funds
Short and sweet…

Liquid Funds are funds that are used by investors for extremely short time durations, such as 1-3 months and in most cases instead of a savings account. In the last one year, liquid funds have returned between 7.7% and 8.85%. Recent data shows that banks are taking fresh exposures in liquid funds which indicate a high degree of safety and confidence in liquid funds. This shows that liquid funds are a good product to invest in if you are looking to fulfill some short-term goals. The changed SEBI rules on liquid funds ensure that you cannot get your units allotted till your money actually reaches the fund by 2 pm (the revised cut-off time) and realistic valuation. Your fund manager’s skills would be tested to the hilt. Fund managers will have to sharpen their skills to be able to dynamically manage the duration of funds and debt papers.

…in a perfect portfolio

Debt funds should be a key constituent of your portfolio. They add more value than passive debt investments such as fixed deposits and other small-saving instruments. You may equate debt funds with liquid funds that offer low returns. But there are many actively-managed debt funds, as discussed, that deliver higher returns, albeit with higher volatility. These actively-managed funds target dislocations in the yield curve and position themselves to profit from them. Debt funds are usually meant for those of you who prefer less volatility, want a regular income, and are willing to take limited risk.