Debt markets are in a tizzy and risk-averse investors are grappling with a limited set of investment options. Inflation and higher interest rates have knocked the wind out of bond prices and the 10-year GOI yield continues to hover in the 7.00%+ region.

The CRISIL Liquid Fund Index appreciated 0.10% over the month (annualised return of 1.2%) to close at 1,133 points (November 18, 2004). Returns posted by liquid funds over the month may appear puny and rightly so, given the volatility in debt markets.

However, consider for a moment the return (or lack of it) generated by long-term debt funds.

The biggest loser over the month in the Debt Fund (LT) segment -- DSP ML Bond has slumped by 0.73%. Sundaram Bond Saver (-0.41%) with the lowest decline is still outperformed by all 5 liquid funds appearing in the liquid fund rankings over the 1-mth period.

Long-term paper is always the worst affected in times like these, when debt markets are in turbulence.

As is evident from the table, gilt funds were the most adversely affected over the 1-Mth period vis-à-vis liquid funds and long-term debt funds. HSBC Gilt Fund (-1.31%) bore the brunt and led the stakes for the losers over the month.

Why the negative returns?
As revealed in the latest Weekly Statistical Statement (as on November 7, 2004) by the Reserve Bank of India (RBI), bank credit on a year to date basis (i.e. from April to November) rose significantly by 17.5%.

The magnitude of the credit surge can be gauged from the fact that bank credit rose only 4.5% on a YTD basis in the corresponding period last year.

Bank deposits seem to have lost their sheen – another important pointer from the RBI Statistic. The YTD deposit growth in this financial year is 7.5%. This is lower than the 9.0% deposit growth one saw in the corresponding period last year.

The faster growth in credit off-take as well as rising inflation (which has prompted the RBI to raise the Repo Rate by 0.25%) have put upward pressure on interest rates. Just to put a number to this, yields on the benchmark 10-year GOI bond have risen by about 2.2% since the start of the year.

What this means is that, prices of bonds offering a fixed rate of return have fallen significantly in recent months. This is reflected in the negative returns posted by debt funds.

Liquid funds on the other hand have done relatively well. Why relatively? Let's look at the returns over the last 6 months.

By itself, an annualised return of 1.20% is dismal. But it assumes significance when you compare it with some long-term debt funds and gilt funds (refer tables above).

For instance, even if one takes a 6-Mth horizon, liquid funds come out tops with gilt funds and long-term debt funds struggling to post a return.

At this stage, liquid funds are still the preferred option for investors who wish to park monies for the short-term (1-3 months).

However, some leading debt fund managers we met in the past suggested that investors who have a slightly extended investment horizon (18-24 months) can consider putting in money at regular intervals in long-term debt funds.

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