Deflated by poor returns? Itís too soon to give up on debt funds

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SummaryCoupled with FII inflows in the space and the spectre of rate cuts, returns were high.

Debt mutual funds have, for long, been the remedy for risk-averse investors. From 2011 onwards and for a better part of 2013, returns delivered by debt mutual funds have rolled on. Coupled with foreign institutional investor (FII) inflows in the space and the spectre of rate cuts, returns were high.

As the rupee touched new lows in August and September and inflation became sticky, the Reserve Bank of India (RBI) hiked interest rates and the spikes in the yield turned the returns table. Even FIIs started withdrawing money from debt. Optimism turned into pessimism. For a fortnight, the returns from even liquid funds ó the category touted as the safest of the safe debt instruments ó delivered negative returns.

The approach

Debt funds play a great role in wealth creation and preservation. A herd approach, with the aim of maximising returns without understanding the requirement, caused a lot of pain to a majority of investors. The obsession with return maximisation, ignoring the risk appetite and product portfolio has brought grief. So, how does one now revisit the debt portfolio investment strategy?

Asset allocation

Itís crucial to understand why you are investing in debt mutual funds. Bank fixed deposit is the only instrument that gives guaranteed returns. Apart from this, just as in any other financial product, there is a risk-reward relationship.

Understand the debt instrument you are investing in. The thumb rule that you can use is to keep the time horizon and liquidity needs in mind. For liquid funds/ultra short-term funds, the investment horizon is 0-3 months. Investors must ensure that the fund portfolio consists of only AAA and above rated instruments with no exposure to gilt funds.

In short-term funds, the investment horizon is 3-6-9 months and, here too, the fund portfolio should consist of only AAA and above rated instruments, investing between 90 and 270 daysí horizon, with zero/minimal exposure to liquid funds. For dynamic bond funds, the fund portfolio should consist of only AAA rated instruments, investing between 90 and 270 daysí horizon, with zero/minimal exposure to liquid funds.

Credit rating

In a rising interest rate regime, the portfolio composition with a bias towards gilt would generate sub-optimal returns compared to an exposure to AAA rated corporate bonds. Again, the maturity period of the instruments held in the portfolio has an impact on the return generated. If these are very complicated, then either understand the product or stick to

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