Existing indicators do not bode well for debt funds over the short term. If one takes a look at the portfolios of leading long-term income funds, it would appear as if even the fund managers agree on that count.

A look at leading long-term income fund portfolios (from latest factsheets) makes one believe that fund managers aren't too optimistic on the interest rate front. A bustling economy and high inflation are enough to put the fear of higher interest rates in the hearts of most debt fund managers.

That explains the shortening of average maturities in debt fund portfolios.

Rising interest rates are not something that loom large only in the Indian context. The American economy is also learning to come to grips with this. A survey by the Federal Reserve Bank of Philadelphia suggests that interest rates in the US will move up by about 80 basis points to 5.0 per cent by the first quarter of next year (2005).

What does this mean for the retail debt fund investor?

It certainly does not mean good times. To begin with, when fund managers shorten their average maturities they have a 'negative' view on interest rates and are trying to play it safe by lowering the portfolio maturity. This is because lower portfolio maturity means lower risk.

As the interest rate scenario at the moment does not merit a cut, and if anything it could be flat or inch upwards, fund managers are being conservative by investing in shorter dated paper. However, shorter paper not only carries lower risk, but also lower return.

If investors have an investment horizon of about six months, investing in long-term debt funds is not a very smart thing to do. This is because returns will be very average and the risk (in the event of an interest rate uptick) is significant. So the risk-reward ratio is not very healthy.

Instead, investors can consider investing in floating rate funds. Floating rate paper works as an 'antidote' in times of higher interest rates and is a product that most investors must own.

However, investors need to tone down return expectations from floating rate funds. Instead, they need to note the benefits the fund brings to the table.

Floating rate funds act as a hedge during a rising interest scenario. They serve to preserve capital well when plain vanilla long-term debt funds are hit hard by the volatility in interest rates.

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