Monday, December 05, 2011


Ride the interest rate cycle…

With a series of hikes over the past year, interest rates have risen sharply and it is likely that they may inch up in the near future. While fixed deposits will fetch higher returns, debt funds may feel the pinch. This is due to the inverse relationship between bond prices and interest rates. When interest rates rise, bond prices come down, which, in turn, reduce the net asset value (NAV) of debt funds. On the other hand, falling interest rates result in a spike in the prices of the underlying bonds, leading to a rise in the NAV. So, when interest rates are increasing, debt funds become unattractive. This does not mean you should completely avoid debt funds as a category. A close scan can reveal funds that are likely to perform better than other fund types even in this scenario. So, if you know how to pick the right ones, you can benefit despite a rise in interest rates. The best way to select debt funds is to look at their maturities, apart from the quality of underlying assets and the liquidity offered. This goes a long way in determining how your debt portfolio will ride the interest rate cycle.

Gilt Funds
Making a comeback

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, thanks to the series of rate cuts undertaken by the RBI. The falling interest rates have translated into an appreciation in prices of long-term bonds and government securities alike. Medium and long term gilt funds, which invest primarily in government securities, have given 2.3% returns in three months, the best in the debt category. They moved up by nearly 0.7% in one month, just below sectoral equity funds and gold exchange-traded funds. Bond yields are expected to remain in the 7.5%-7.7% band. Of course, you must understand that to make the most of your gilt fund investments, being invested for the long haul (to cover an interest rate cycle) is important.

The prodigal’s son

With the high interest rates, the rates on Fixed Deposits are also increasing, so why are investors looking for FMPs? Though FMPs are advantageous for all kinds of investors these work best for those who earn above Rs 5 lakhs and fall under the tax bracket of 30%. On bank fixed deposits you pay 10% TDS (you can avoid the TDS by submitting Form 15G) and another 20% tax on interest received on fixed deposits when you file the return for income tax (assuming that you pay personal income tax in the range of 30%), but in FMPs tax rate on capital appreciation is 11.22% without indexation( it is a technique to adjust income payments by means of a price index, to maintain the purchasing power of the public after inflation) and 22.44% with indexation benefit. Another advantage with FMPs is that they can be used to park funds temporarily in volatile markets. Most FMPs provide returns that are at least 2-3% higher than the rates of fixed deposits . So if the banks give an average of 9% now, you can expect around 11-12 % of returns.

Income funds
The black sheep

Income funds, which invest a majority of their portfolio in short- and medium-term instruments, were the worst performers in the debt fund category on account of a hardening of short-term yields due to the prevailing tight liquidity situation and expectation of a rise in inflation. Income funds gave a return of 0.84% as compared to 1.4% in gilt funds and 1.71% in liquid funds. Yield on the one-year Certificate of Deposit firmed up by 145 basis points and credit spreads across maturities widened as corporate bond yields hardened more than the yields on government securities. While this negatively impacted the performance of income funds, the short-term debt categories benefited.

Floating Rate Funds
Lacklustre presence

The primary reason for lacklustre presence of floating rate funds in the mutual fund industry has been investor ignorance of the nature of floating rate funds. There is a shortage of sufficient long-term floating rate instruments. Because of this, fund managers divert certain portion towards fixed interest securities. 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. Floating rate funds vary from conventional fixed rate investments mainly on the basis of coupon rate i.e. the coupon is revised at regular intervals (means floating) with respect to change in the benchmark rate. Consequently, if there is a rise in the interest rate, the coupon rate usually reflects this change, thereby, securing the interests of investors during rising interest rates. Usually investors turn to these funds when they look for safety for their investments. Considering the fact that not a single long term floating rate fund has slipped into the negative terrain suggests that the performance of the floating rate funds have been quite good. Investors looking for capital preservation during times of rising interest rates cannot afford to ignore floating rate investments. However, they must note that while floating rate funds do well in a rising interest rate scenario, when the scenario turns (i.e. interest rates fall), floating rate funds underperform their fixed rate counterparts.

Liquid funds
Attractive alternative to bank accounts

A recent study carried out by CRISIL Fund Services concludes that liquid funds offer an attractive alternative to retail investors vis-à-vis parking idle funds in a savings bank account. Not only do liquid funds offer higher post-tax returns, they also provide a reasonable degree of safety in terms of the principal invested. Moreover, these investments are highly liquid. They can be redeemed within 24 hours and have no exit load. Further, liquid funds invest in securities with a maximum maturity of 91 days, which cuts down the credit risk. Most liquid fund schemes are also highly rated (P1+f), signifying very strong protection against losses from credit defaults. Over the last 5 years, liquid funds have given an annualised post-tax return of 5.78% as compared to 2.5% given by a savings bank account. Within liquid funds the dividend option is more tax-efficient. This option would be more suitable for investors who fall within the 20% and 30% tax brackets, as it attracts a lower dividend distribution tax of 12.5%. Post tax deduction, liquid funds yield better returns vis-à-vis savings accounts and fixed deposits, wherein the interest earned would be taxed based on an individual’s tax slab.

…to savour the flavour of debt

Depending on the interest rate outlook, investors should alter their debt portfolios in favour of products with suitable maturities. Depending on the tenure, the sensitivity to interest rate movements varies across debt funds. Shorter duration funds are not affected as much by interest rate fluctuations as the long-term ones. So, if the rates are falling, you should invest in longer maturity debt funds, such as income funds and gilt funds. However, in a rising rate scenario, short duration plans such as liquid funds, ultra short-term funds and fixed maturity plans (FMPs) are the right choices. So it is advisable to have a debt fund portfolio with adequate allocation for various categories so that you are well placed to benefit from various phases of the interest rate cycle.

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