For instance, the yield on a one year triple A paper is currently around11.25 per cent, while the yield on a G-Sec of similar maturity is 10.25 percent. ``Besides generating better returns, gilts carry zero credit risk,''says Shekhar Sathe, CEO, Kotak Mahindra Asset Management Company. Forinstance, Dundee Sovereign Trust, the gilt fund from Dundee Mutual Fund, hasgiven a return of 5.14 per cent in the last three months.

Other funds like Tata GSF and Prudential ICICI Gilt (Investment plan -growth) has generated returns in excess of 4 per cent. The investment plan(long-term) from Kotak Mahindra AMC has also given a return of 3.11 percent, while the savings plan (short-term) has appreciated by 2.40 percent.

However, all has not been hunky-dory with gilt funds. Since gilts are highlyliquid, the NAVs of gilt funds have been very volatile on certain occasionsand this has hit returns from these funds. ``With fresh auction ofgovernment paper, traders have dumped G-Secs in their portfolios and thishas led to a sharp fall in prices in the last couple of days. Hence, onlythose investors should invest in gilt funds who can withstand thevolatility,'' says a fund manager.

On the other hand, the best performing debt fund has been Tata Income, witha return of 3.91 per cent. PNB Debt is a close second with a quarterlyreturn of 3.87 per cent. Interestingly, the fund has invested a bulk of itscorpus in government securities. Although the monthly income plan fromAlliance has been the top performer (9.37 per cent), the fund has been leftout since it has invested of its corpus in equities.

Fund managers expect the gap between G-Secs and corporate paper to widenonce credit offtake picks up and demand for money leads to tightening ofinterest rates. ``So far, interest rates have remained soft and the surfeitof liquidity in the system, with subdued call rates, has led to a sharpspurt in gilt prices. Although demand for credit has gone up, it is notreflecting in interest rates due to ample liquidity in the system,'' says afund manager. ``However, a stronger pickup in credit offtake may put anupward pressure on interest rates though a lot depends on how RBI reacts,''he adds.

``Incremental credit disbursal this year has been higher at a time when theincremental deposit growth has been lower compared with last year. Normally,this would have led to a tightening of interest rates. However, there aretwo reasons for this not having happened.

One is that the structure of the debt markets has changed with higher numberof participants, namely mutual funds who bid very aggressively for goodquality assets and second, the RBI has been proactive in providing liquiditysupport to the banks and PDs either through re-finance or through openmarket purchases of T-Bills,'' says Sridhar Narayan at Zurich AssetManagement Company.

With declining returns from their debt funds, some funds have put a part oftheir corpus in AA and A paper to enhance yields on the portfolio. ``Thereis some merit in the strategy of buying lower quality paper, but it reallydepends on the nature and positioning of the mutual fund product,'' says afund manager.

``We have moved a part of our portfolio to AA-rated paper as returns fromAAA paper have gone down, although it does lead to a problem from someinvestors since some funds harp on credit quality and play up theirall-triple A portfolio,'' says a fund manager. ``There are a number ofcompanies in the market that continue to have a AA or A rating though theyhave emerged much stronger after restructuring.

We have been investing in debt paper of such companies,'' points out anotherfund manager.

However, liquidity is an important issue facing fund managers when it comesto investing in lower quality paper. ``It is a buy-and-hold investment.While it definitely improves returns, the problem with AA or lower qualitypaper is that it lacks liquidity. It is This can lead to a problem duringredemption pressure,'' says Akhilesh Gupta at Dundee Mutual Fund.