With equity markets displaying significant volatility in recent days, a natural outcome was for debt funds to come back into focus. The main reason behind this phenomenon was that the comfort that investors had with investing in equity, even for short periods of time, started wearing out due to emerging volatility characteristics.

On the other hand, interest rates and yields have been rising for a while now. Increasingly, risk adjusted returns from fixed income products were getting attractive.

Need for debt funds in current market conditions:

The fact of the matter is that all investments should be backed up with a solid investment plan, which helps investors decide on the time period for which they wish to invest. This analysis is crucial in deciding the risk characteristics of their portfolio, which in turn will have an impact on returns. Ideally, this should remain unchanged without regard to market conditions, but this rule is more flouted, than followed, in reality.

Potential of debt funds in volatile markets:

There are a slew of debt mutual fund products available for investors. These should be a part of any investor's asset allocation at all points of time. Starting from liquid funds, which predominantly cater to extremely short term (< 1 week) surpluses to income funds (> 6 months), the mutual fund industry offers products of all risk - return and liquidity characteristics.

The presence of debt funds in an investor's portfolio will protect it against volatility-induced losses that a pure equity portfolio will normally be exposed to. To put it simply, greed and fear are two sides of the same coin and an investor's greatest enemy. To avoid fear, one has to protect against greed. In this context, if an investor invests short-term funds in the equity markets, at some point fear of losses will become a reality.

Today, investors have various options to invest their surpluses in various debt oriented mutual fund schemes. Fixed maturity plans, which may indicate a return over a fixed investment term, can provide a tax efficient alternative to Bank FDs. In addition to these basic products, investors have the option to invest in open ended debt oriented products which offer higher liquidity, but market related floating returns.

Why FMPs are more lucrative than bank FDs?

Till recently, the only open-ended debt products being actively offered to investors were liquid funds. These products, which are designed for overnight and extremely short-term surpluses, were used as an investment option for all investment periods.

However, with the recent rise in interest rates and yields, slightly longer-term products are also looking attractive on the risk - return matrix. These products, like the liquid plus and short term funds, assume higher interest rate risk, but offer higher returns to balance this risk. However, it is essential that investors use these products for investment time periods, which are longer than that for the liquid fund to negate the risk of volatility in returns.

How can retail investors select the right debt fund?

In selecting the right debt fund for investments, primary focus, as with all other investment options, has to be on the time period of the investment. While liquid funds suit extremely short investment periods of even a day, a product like the liquid plus fund supports investment periods of at least one week.

Daily returns in these schemes are more volatile than those generated by liquid funds. However, this volatility evens out for periods of more than a week and these funds may be expected to deliver slightly higher returns than the liquid funds over this period of time.

At the next step are schemes like short term funds, which may offer volatile weekly returns, but have the potential of delivering higher returns over investment periods of a month or more.

Interestingly, volatility in the equity markets has led to a resurgence of a quasi debt product in recent days. Arbitrage funds, which aim to derive a benefit from price mismatches between the spot and futures price of the same stock have the potential of delivering superior returns when equity markets are volatile.

Equity oriented arbitrage funds offer a tax efficient route to such investments, which is an added attraction when compared to debt oriented arbitrage funds. Investors should choose these schemes carefully to derive maximum benefit from them. Also, it is advisable that investors stay invested in such funds for a period of 3-6 months to achieve consistent returns.

In conclusion, there is a debt oriented mutual fund scheme available for every need. To choose one, all an investor needs to know is the investment time period. Very few things in life are as simple!

The writer is head - Alternate Businesses, Lotus India Mutual Fund.

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