The equity funds investing in stocks of companies are highly volatile and hence fall in a high-risk category. The debt funds, on the other hand, limit their volatility since credit and interest rate risks are far less than the risks of investing in equity funds. Thus debt funds come to have a special appeal to the risk averse investors seeking safety of principal and the cushion of steady returns or income. However, for the steady returns by the debt funds, their importance as a part of every investor's long term investment portfolio cannot be overemphasized. Why are debt funds a good alternative vis-a-vis bonds and fixed deposits?

There are a number of benefits. Firstly, diversification, which means that for a small amount of money you gain by owning fixed income papers across a wide array of companies and industries. A similar amount of diversification is not possible for investors investing on their own.

Secondly, investing in debt funds always has the benefit of professional expertise of the fund manager, who is responsible for monitoring and actively investing when interest rates and credit quality change. Thirdly, investors benefit from the liquidity and the convenience of investing at any point of time. Besides, debt funds in their growth options offer the option of systematic withdrawal plans (SWP), which if exercised after a period of twelve months reduce the capital gains tax liability.

SWPs are a better option than the dividend option as the investor can escape the dividends tax being charged from his investment. As a result, in an open-end income fund, you get the benefit of high returns with the liquidity similar to that of a savings bank account.

However, debt funds do not guarantee any returns. There are many investors who look for a fixed amount of return year after year, believing that assured returns are safe and that they stand to gain without any risk. However, they fail to realise that they may be exposing themselves to a much bigger risk, risk of not keeping ahead of inflation.

Consider, a case where one has locked his money into a scheme assuring a return of 12 per cent per annum for the next five years and the rate of inflation, during that period goes up to 15 per cent pa, suddenly the investment would no longer be attractive. In fact, one would stand to lose after accounting for inflation. Furthermore, today the interest rates are market driven and volatile, it may be dangerous for a scheme to guarantee returns for a longer time period. That is precisely the reason why monthly income options (MIPs) of UTI have started guaranteeing returns only for one year. Further, government securities, that are the safest of the investment avenues for the zero credit risk that they carry, can be invested in only through the debt funds.

Risks involved: Although the debt market is nowhere nearly as volatile as the equity market, debt products are broadly subject to three types of risks - interest rate movements, liquidity and credit.

Interest risk: The two major monetary tools available with the RBI that directly impact the prices of debt instruments are the changes in the CRR (cash credit ratio) rate and the bank rate. RBI's open market operations (OMO), whereby the liquidity in the system is infused or sucked out, also indirectly impact the pricing of the debt instruments, albeit marginally and for a shorter duration. RBI uses any of the above tools to deal with situations internal to the economy such as inflation, economic growth, or due to extraneous factors such as forex volatility or east Asian crisis.

Values of debt securities vary inversely with changes in interest rates (bank rate). Consider a scenario where interest rates are rising. As a result the existing fixed instruments, that will continue to earn interest at a lower rate, will be traded in the market at a lower value. Further, bonds with longer maturities have greater exposure to interest rate changes and will usually experience more price volatility than shortterm bonds.

Thus as interest rate rises, the price of a long term bond will drop more sharp than the price of a short-term bond. Hence a debt fund that, in the event of an interest rate hike, has a longer maturity profile will see a higher fall in its net asset value (NAV) than a debt fund having a smaller maturity profile.

The reverse is true for a fall in the interest rate. The existing fixed instrument papers, will in the eventuality of an interest rate cut see a rise in the prices at which it will be traded. And longer the tenure of the underlying instrument, higher would be the rise in its traded price. Hence, a debt fund that, in the event of a slash in the interest rate, has a longer maturity profile will witness a sharper rise its NAV as against a fund having a smaller maturity profile.

Now consider a drop in the CRR. A CRR cut infuses liquidity in the system. This in turn will soften the outlook for the interest rates, thereby raising the prices of the existing debt instruments. On the other hand the tightening of the CRR will have the opposite effect. Liquidity risk Liquidity is a fund's ability to encash its debt holdings with minimum impact cost. The market for debt instruments is dominated by the government securities (gilts), which are also the most liquid instruments. Hence, higher the exposure to gilts, lesser the liquidity risk (but the interest rate risk of the fund will also be higher). On the other hand a higher stake in corporate bonds does expose the fund to liquidity risks which get compounded if a fund compromises with the credit quality of the underlying instrument.

Credit Risk: Debt securities are also subject to the risk of an issuer's inability to meet principal and interest payments on the obligation. The credit worthiness of the issuer of an instrument can be very well known by the credit rating it enjoys from the independent rating agencies. The rate of interest offered by the issuer of the instrument is inversely related to the credit rating the issuer enjoys. Poorer the credit quality, higher the risk involved and hence higher the rate of interest offered. With the government securities involving no risk of default, these feature at the top of the safety ladder.

Selection of a debt fund: An investor will have to consider his investment horizon, the investment objective-capital appreciation or regular income and also the risk taking appetite. The risk profile varies from one debt fund to another. Accordingly, the investor has to select a fund which meets his selection criteria. Having done the initial screening, the investor will have to consider other factors too - the cost of participating in the fund in terms of the load at the time of entry as also the annual recurring expenses charged by the fund. Since returns from a debt fund are low, the cost factor will make a big difference.

Another qualitative factor would be the investment strategy/discipline of the fund. A fund with higher allocation to instruments in the lower order of credit quality or with a very high weightage to particular instrument will be more risky. Also, the fund manager has to strike the right balance between corporate debt and gilts.

-- Value Research