Comparative Analysis of Debt MFs in the long run

The general perception about debt mutual funds is that they are meant for risk-averse investors and provide a reasonable fixed income. This suggests that debt mutual funds are safe and secure, but that is not the case. Investments in these funds are also subject to risks. The main risk is in the form of interest rate movements, which can induce volatility in the fund returns. Moreover, volatility in some phases can be even higher than that of equity fund schemes.

On the other hand, debt mutual funds can prove to be an effective technique for cash management and portfolio diversification if entry in these funds is timed properly. In this article, we will analyse returns generated by different types of debt fund schemes over different time periods, and also find out what type of scheme to be used depending on the interest rate scenario in the economy.

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Liquid Funds

Liquid fund schemes are the schemes that invest in money market instruments with the lowest average maturity, for example, ten days or a month. These funds provide returns, a little over bank savings account returns. True to their name, they are meant to provide liquidity to investors while ensuring higher returns than savings accounts. As per the latest SEBI guidelines, all securities in which liquid schemes invest should be less than 90 days in maturity. The returns of these schemes are primarily based on interest accruals. The performance of liquid fund schemes over the past few years has been tabulated as follows:

Source: AMFI, NSE, BSE

What we see here is the returns have consistently exceeded savings account returns as desired.  However, a downtrend has been witnessed in these returns due to the fall in interest rates since last September in the wake of monetary actions taken by the RBI after the global credit crisis. The reason to invest in this scheme is that the returns are again expected to rise as the RBI is expected to hike policy rates from the next financial year.

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Liquid Plus Funds

These schemes are an improvisation of the conventional liquid fund schemes. Even though they do not have a maturity restriction on their assets, they primarily hold assets with a maturity of less than one year. Returns are again mainly based on interest accruals but fund managers try to boost the returns by actively churning the portfolio and booking some capital gains.

These schemes hold some mark-to-market securities in their portfolio. Mark-to-market securities means the securities whose gains or losses have to be reflected in the profit and loss statement. These securities provide the extra boost to the returns. The performance of liquid plus schemes is condensed in the following table.

Source: AMFI, NSE, BSE

It is evident that the returns of liquid plus schemes are marginally higher than that of conventional liquid schemes. The higher returns are mainly on account of the marginally higher risk taken. These returns are expected to improve on account of expectations of rate hike by the RBI in the next fiscal.

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Short-term Funds

Short-term fund schemes are more prone to interest rate risks as compared to liquid and liquid plus schemes. These schemes primarily invest in assets with an average maturity of 2-3 years, most of which are mark-to-market assets. Returns are generated by means of capital gains as well as interest accruals, and are higher than that of liquid and liquid plus schemes. However, the higher risk also creates a possibility of negative returns for these schemes. Now let us see how these schemes have performed over a period.

Source: AMFI, NSE, BSE

The table shows that these schemes have performed poorly vis-à-vis liquid and liquid plus schemes due to the high levels of volatility observed in the short-term bond rates in the market. The key to earn good returns in the schemes is to time the entry and exit correctly.

Gilt Funds

These funds invest in government securities. They can have different maturities depending upon the risk appetite of an investor. Gilt funds can either be short term or long term. The higher the maturity profile, the higher will be the risk return profile of the scheme. The investment strategies adopted by these schemes are similar to that of short-term funds. The basic difference between the performance of these schemes and short-term funds arises from the fact that the underlying assets in these schemes, i.e., government securities are much more liquid than the underlying assets of short-term funds, i.e., corporate bonds. The average performance of both the long-term and short-term gilt funds is tabulated below:

Source: AMFI, NSE, BSE

The performance of these funds pales before that of liquid plus and liquid schemes. The reason is the presence of volatility in movement of rates of government securities. The period of sustained fall in rates was observed from September 2008 to March 2009. If we take isolated returns during this period, the returns will turn out to be very high. Going forward, with rates expected to rise, the chances of sustained positive returns are low. The entry and exit have to be timed in the short term to take advantage of any positive movement in the returns.

Conclusion

Debt funds are not completely secure; they also provide different risk and return profiles like equity funds. Returns in these funds are impacted by volatility induced by interest rate movement. These schemes provide good returns if chosen carefully by the investor. The returns can be maximised by timing entry and exit properly.

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