With a large number of open-end debt funds today, investors have the flexibility of investing and redeeming at will. Although debt funds have historically been considered a placid investment, the last few months saw the debt markets on fire with returns from the "safe" investment vehicle taking a plunge. However, this not surprising since a host of factors - government's huge borrowing programme, rising global interest rates, falling rupee and oil prices created quite a flutter in the debt markets. No wonder, interest rates started to firm up, which pulled down the prices of debt instruments. This lead to sharp erosion in net asset values of bond funds.

Interest rates and prices of the debt instruments are inversely related and when interest rates move up, the impact is that the fall is more pronounced in longer dated securities. Although fund managers made a fierce attempt to reduce the maturity tenure of their funds (average maturity profile was 2.08 years as on September as against 5.69 years as on February 2000), the impact of the flurry of negative events did get reflected in the returns from bond funds.

Consider the average 3-month return by Value Research's Medium-term debt funds for the months ending July, August and September. The three-month returns were paltry at 0.8, 0.44 and 0.94 percent, respectively. While most panic-stricken investors stayed invested, some funds were still faced with redemption as money moved to short-term debt funds.

However, the month of October not only brought a breather for the harried markets but also seems like a prelude to relatively better times. Debt markets turned bullish at the back of announcement of the issue of India Millennium Deposits (IMD), an overseas bond issue on the lines of Resurgent India Bonds (RIBs) issued in 1998. The three-month return for October 31, 2000 vaulted upto 2.1 per cent, which signifies a marked change in the sentiment.

Fund mangers have also shared the optimism by marginally increasing their maturity profiles. For instance Sandesh Kirkire, from Kotak Mahindra AMC, says he has increased the average duration of the Gilt fund to about 3 years while that of the Bond fund to about 2.25 years. Similarly, Nilesh Shah of Templeton India AMC has over the past two months increased the maturity tenure of both Templeton India Income fund and Templeton Government Securities fund by half a year.

While, the general expectation is that the short-term rates will further ease with fears on the forex front allayed with IMD issue, the uncertainty on the oil front has resulted in fund managers taking a cautious approach. They still maintain a defensive portfolio as it is too early to go too far on the maturity ladder. Understanding risks and avoiding overreacting: Given the volatility in debt markets in the last few months, it would be a misconception to think that investments in debt funds are totally risk-free.Though debt funds are far more stable than their equity counterparts, interest rates are closely linked to the macroeconomics and thus, are very dynamic. Nonetheless, the time span of turbulence in the debt markets is far short-lived that that in the equity markets. Therefore, any panic-stricken decision to move out of debt funds would mean overreacting to a short-term aberration. Apart from the interest rate risks other risks are:

Liquidity risk
The market for debt instrments is dominated by Government Securities (Gilts), which are also the most liquid instruments. Hence, higher the exposure to gilts, lesser the liquidity risk of the fund. On the other hand, a higher stake in corporate bonds (especially of lower credit quality) exposes the fund to liquidity risk.

Credit risk
The rate of interest offered by the issuer of the instrument is inversely related to the credit rating the issue enjoys, where credit rating implies the issuer's ability to meet principal and interest payments obligation. Poorer the credit quality, higher the risk involved and hence higher the rate of interest offered. Some parameters to decide bond funds:

Risk profile
Since longer dated instruments carry higher coupon, an aggressive fund would keep a large portion of its assets in these instruments to generate better returns. Hence, an aggressive fund could lose sharply in the event of any sudden hike in the interest rates.

A conservative fund, on the other hand, would try to play safe any wild shocks on the interest rate front and tend to steer away from long dated instruments. While, these funds in the long run would yield slightly lower returns than their aggressive counterparts, they would be less risky as well.Load structure and expense ratios - While debt funds normally do not charge any entry load (except Jardine Fleming India Bond fund that charges 1 percent entry load for investments upto Rs 1 lakh), they levy an exit load ranging between 0.25 to one percent for redemption within three months to one year. The expense ratios of debt funds can range anywhere between 1.25 to 2.5 percent%. Since expense ratios are deducted from the assets under management, a lower expense ratio adds to the net asset value.

Size of the fund
The constraints in managing a large sized fixed income fund are many, primarily due to the lack of depth of the debt market. The paucity of quality assets forces a large sized fund to have a higher allocation to either government securities or corporate instruments, which are lower on the credit quality ladder. While the former exposes the fund to interest rate risk, the latter could lead to liquidity problems.

A higher exposure to gilts also makes the returns quite volatile as these instruments are the first to get hit in the wake of interest rates moving up. While the volatility in debt markets has surely knocked off a few percentage points from most debt funds in the current year, the bond family still continues to be an attractive investment option. Apart from largely steady returns, debt funds offer the convenience of easy liquidity, periodic investments and withdrawals and active management. As for the hiccups in the bond funds, you would have to live with it as global events cast a shadow over domestic markets!

Value Research