Debt funds: What's good for you

The finance minister has taken several measures in his Budget to boost domestic consumption, but these steps also bring bad news for debt investments. Post-budget, economists believe there will be upward pressure on interest rates, which, in turn, will lead to fall in yields in the debt market.

Bank fixed deposit (FD) rates have, since October, slipped quite sharply. At present, they are within the range of 7-8 per cent. And while there are expectations that interest rates will firm in the next 6-12 months, there isn't much clarity about when the government borrowing will begin and how the Reserve Bank of India will manage it to minimise the impact on interest rates.

So, for FD investors, there aren't many options. If they have idle cash, they might as well invest it in the existing products. At least, it will earn more than the bank savings rate of 3.5 per cent. For debt fund investors, however, there are specific strategies that could help them benefit from future rate movements.

But, before getting into details of these instruments and strategies, let's look at the factors that could lead to a rise in the interest rates.

Interest Rates

To make up for giveaways in the budget, the government will most likely need to borrow huge sums of money. This rise in borrowing would lead to pressure on existing liquidity in the market. And if the government corners a significant amount of this liquidity, banks would fall short of cash and will have to increase rates, to attract funds from depositors. Rising interest rates, consequently, mean a fall in the yields.

"There is pressure on the long-term interest rates. The yields for 10-year government bonds are already high, at around 7 per cent," said Sonal Varma, India economist at Nomura.

If RBI tinkers with any of the policy rates or there is pressure on market liquidity, while FD rates could rise, returns from your income and gilt funds would slip. In such scenarios, investment advisers recommend that investors look at strategies to get the optimum return.

Short Term

For short-term investments of less than a year, investors could look at a whole host of fund categories that invests in short-term papers. These include ultra short-term funds, liquid and liquid-plus funds and floating rate (short-term) funds. These funds invest in short-term papers and thus generate returns at par with the prevailing interest rates.

These funds not only give returns at par with bank FDs, they are also more tax efficient for investors in the tax bracket of 20 per cent or higher. For instance, the post-tax return in the worst performing floating rate short-term fund, BS Chola Short Term Floating Rate, is 4.82 per cent for a year.

This is equivalent to 8.82 per cent in a bank FD for a person in the highest income tax bracket. Magnum Floating Rate ST, the best performer in the past one year, gave 9.3 per cent returns.

Medium Term

For investment over a year and less than three years, investors could look at floating rate long-term or short-term funds'. The worst post-tax return for a three-year period for a fund in the floating rate category is 6.42 per cent (Tata Floating Rate LT). The best performer, HDFC Floating Rate Income, gave returns of 8.66 per cent in three years.

You can also investment short-term funds till there is clarity on the interest rate. Then, lock your investment in a bank FD, whenever you are comfortable with the returns.

If you can handle the volatility involved in mutual funds, there are floating rate deposit schemes that many financial institutions offer. For instance, HDFC's variable deposit currently offers 7.9 per cent floating interest.

Long Term

Many financial planners suggest income funds for the long-term. These funds are generally classified as medium-term debt funds. This category is the second most volatile after gilt funds, as they invests in long-term papers and also trade in these. But they also have the scope of offering higher returns than short-term funds.

In the past year, there are four funds in this category that have given over 20 per cent returns. These include Fortis Flexi Debt (21.14 per cent), DWS Premier Bond (21.51 per cent), ICICI Prudential Income (25.63 per cent) and Canara Robeco Income (30.62 per cent).

Another strategy that investment advisors recommend is putting money in two short-term and long-term funds. For instance, a person can invest in a floater fund or a liquid fund with income fund. "This will make the returns stable even when income funds would be volatile," said a certified financial planner.

The returns from these investments will obviously depend on the selection of funds. While evaluating these, financial planners suggest a look at the portfolio. "Funds that invest in papers of highly rated companies will yield more stable returns. Also, investors should avoid funds that invest in complex instruments, such as asset-backed securities," said Suresh Sadagopan, a Certified Financial Planner. He also cautioned on investments in gilt funds, as they are the most volatile fund category.