A lot has been said and written about debt funds in recent times. If popular perception is to be believed debt funds are history!

The last three months have been rather rough on debt markets and debt funds respectively. Declining returns have become a regular feature and there seems little reason to believe that the situation would be significantly different in the near future.

The same time period also coincided with the ascent of a new breed of hybrid instruments i.e. monthly income plans. MIPs which invest a substantial portion of their corpus in debt instruments (75-85 per cent) and the balance in equities (15-25 per cent) emerged as favourites. A large section of the investors chose to liquidate their debt fund holdings to invest in these MIPs. While MIPs are a sound investment avenue, they are not a perfect replacement for debt funds.

Debt funds were designed to attract investors who were seeking stable yet market-linked returns. They were positioned as instruments which would beat fixed deposits. MIPs on the other hand, despite the relatively small equity holding are a riskier proposition. With equities entering the picture, investors end up dealing with a completely different asset class that may not suit their profile.

Interest rates have virtually bottomed out in the country. The economy is on the rise with GDP growth rates being consistently revised upwards. Despite Reserve Bank of India's optimism, inflation figures have been on the upswing too. All the factors are broadly indicative of interest rates moving up. At times like these investors should position themselves to take advantage of the changing scenario. Should the interest rates move upwards long-term illiquid investments in fixed deposits and government savings schemes could turn out to be loss making propositions.

While the irrational returns from debt funds (triggered by a series of rate cuts) may be a thing of the past, debt funds aren't. Disposing off debt funds from your portfolio and moving into a different asset class (like MIPs since you take exposure to equities as well) would mean altering your asset allocation. Instead investors should consider divesting a part of their holding and investing in some of the innovative schemes within the debt funds category. Floating rate funds and funds which invest in low grade paper are options to be considered.

A floating rate instrument is benchmarked against a market-driven rate like the Mumbai Interbank Offer Rate, for instance. So every time the MIBOR fluctuates, the coupon rate on the instrument is adjusted accordingly. That is why the coupon rate is referred to as 'floating rate'. If the interest rates move upwards so will the coupon rate on your instrument.

Similarly debt funds, which invest in low rated paper could experience a windfall in the days to come. When the economy booms and companies turn profitable, their credit ratings are revised upwards. The prices of bonds issued by such companies also move up. Changing markets scenarios don't change your risk profile or appetite.

If you were risk-averse before the equity markets rallied you should continue to be risk-averse now as well. Make sure you exhaust all options available to you before jump asset classes. While there is nothing intrinsically incorrect with moving across asset classes, ensure that you are aware of the risks involved.