In the last few years debt funds have not been of investor interest, and not without reason. With an average 3-year return of 4.7 per cent, these funds had little to offer investors who were seeing their equity fund portfolios returning 48 per cent in the same period. The likes of bank fixed deposits and post office monthly investment schemes had supplanted debt funds.

But all this is in the past. Debt funds are making a comeback. So, is it time for investors to take a relook at them?

The story so far

Debt funds were on a roll till early 2003. Interest rates had come down from 14 per cent to below 7 per cent, and debt funds were a direct beneficiary of this. Unlike products like FDs and POMIS, they generated returns both from interest income and the gains from the increase in the value of the bonds.

Bond prices and interest rates have an inverse relationship, that is, bond prices tend to increase when interest rates fall, and vice-versa. Once interest rates bottomed out, bond prices and debt funds found their annual returns falling to as low as 5 per cent.

The debt investor got better results from administered return schemes such as POMIS, NSC and RBI bonds. Funds such as HDFC [Get Quote] Income Fund and ICICI [Get Quote] Prudential Income Fund, which were managing assets of more than Rs 3,500 crore (Rs 35 billion) in 2002, saw the size shrink to below Rs 300 crore (Rs 3 billion).

What lies ahead

Reserve Bank of India [Get Quote] had to step in to curb the high inflation in the economy since the beginning of 2006. This has led to a cooling of interest rates. But, is this just a short-term reaction to RBI's measures, or are lower interest rates here to stay?

Amandeep Chopra, president and head of fixed income, UTI Mutual Fund, expects interest rates to be range-bound and flattish before declining. He, however, feels that interest rates may go up in the interim. Nandkumar Surti, senior vice-president and head of fixed income, JP Morgan Mutual Fund, adds that global volatility and rising oil prices are triggers that could harden interest rates in the short term, though a softer regime is possible in the long term.

Clarity is also required on the inflation figures before taking a view on interest rate movements in the short term.

Shabbir Kapasi, vice-president, fixed income, HDFC Mutual Fund, feels that the factors that led to high inflation in the economy - high asset prices, smart GDP growth with demand outpacing supply - are still there. He says that an appreciating rupee and the increase in demand for imports will further fuel inflation in the near future.

What seems clear is that while interest rates will soften in the long term, short-term movements are unclear.

What it means for investors

Softening interest rates will result in increased price of bonds and, therefore, higher returns from bond funds. Funds with longer portfolio maturities and duration will stand to gain more. "Investors must slowly increase the average maturities profile of their debt fund holdings to benefit from the anticipated rally," says Chopra.

Fund houses have also been redoing their bond fund portfolio in the last few months by increasing modified duration to benefit from a rally. The average maturities of the portfolios, which had fallen to a low of around 2 years from 5-6 years in 2002, have also shown an increase.

HDFC Income Fund and ICICI Prudential Income Fund had average maturities of 7-8 years in their May portfolio. Such funds will stand to gain the most in an upswing in bond prices. They will, however, also lose the most if things go in the opposite way.

While evaluating bond funds, investors must look at factors such as the credit quality, average maturity and modified duration of the portfolio to assess the risk and return characteristics of the fund.   

While there is no doubt about the bond market's resurgence, investors should wait for an easing trend in interest rates before committing funds. Sustained fall in inflation, backed by a real fall in prices, would be one indicator.

Rajeev Shastri, head, alternate businesses, Lotus India Mutual Fund, looks for better direction from the RBI in containing volatility in the overnight rates that has been fuelled to some extent by the cap on absorbing liquidity imposed by the RBI some months back. This would give a clearer picture, he says.

Investors need to have a time horizon of 6-12 months to be able to insulate themselves against these short-term uncertainties. Surti says investments should be made in 2-3 tranches as a strategy to tackle the uncertainty. Investors also need to be realistic about the returns they can expect from the funds - 9-10 per cent in the one-year horizon.

Why debt funds

Investment in debt forms a part of every investor's portfolio, either as debt funds, fixed deposits, PPF or bonds. Tax efficient returns and diversification of assets are some of the reasons why debt funds will play a bigger role in an investor's portfolio.

Tax-efficient returns. With debt funds poised to give 9-10 per cent returns, they are comparable to bank FDs, and better than the administered return schemes to this end. Add to it the tax benefits. Unlike interest from bank deposits, which are taxed at the marginal rate of taxation applicable to the investor, dividends from debt funds are exempt from tax. The fund, however, has to pay a dividend distribution tax of 15 per cent, and long-term capital gains from debt funds are taxed at 10 per cent.

Rebalancing the portfolio. Equity funds have given investors outstanding returns in the last four years. With markets touching new peaks every day, it is probably time for prudent investors to rebalance their portfolios by booking long-term capital gains in equity funds.

Income funds or debt funds can be used to park such gains. Moreover, investors can use tools such as systematic transfer plans to periodically invest in equity  markets when valuations become attractive again.

Diversifying and derisking the portfolio. A portfolio must be diversified across asset classes to be able to give good risk-adjusted returns.  Debt forms an integral part of every portfolio to this end. Debt funds are primed to give good returns along with lower volatility, liquidity tax efficiency and convenience.  

What should an investor do?

It is time for investors to bring medium-term debt funds back on their radar. This is especially true for those who are planning to commit funds to FDs or POMIS. Evaluate debt funds before entering investments that will tie up funds for a long time.

Investors also need to move away from the interest rate risk-neutral debt funds such as fixed maturity plans, floating rate funds and liquid funds, and look for funds that will benefit from mark-to-market gains.