The average gain in the Value Research's category of medium-term debt funds over the same period was 0.48 per cent, which translates into a whopping 25 per cent return on an annualised basis. Though such towering returns from debt funds are unthinkable, it is just a gauge of the feel good factor in the debt market. The Federal rate cut has further strengthened the positive sentiment after the IMD inflows in November last year triggered a bull run in the bond markets. Going forward, interest rates are expected to continue to soften with the markets eagerly awaiting a cut in interest rates.

While the turnaround in sentiment has been remarkable after bond markets were battered by a interest rate hike in July last year, investors must learn to overlook these short-term disturbances and stay invested during the longer haul. If you withdrew investments from bond funds in panic after the debt bloodbath in 2000, you would be feeling foolish today.

Similarly, investors today are flocking to debt funds as the markets have rebounded. The AMCs are also trying to make the best of this opportunity by either doing away with period-linked exit loads or slashing the minimum no load period. However, this attempt to time the markets could again boomerang on investors. When investing in bond funds, it should be amply clear that debt markets are also subject to ups and downs, though the amplitude of the swing is not as high as equity markets. Thus, debt funds also run the risk of loss of capital.

Where investors have a limited access to information, there is a strong possibility that they end up risking their investments in a particular company that may not be high on the credibility ladder.

Hence, a better option is to invest in debt funds. These funds are backed by the professional expertise of fund managers, who not only guard against any possible deterioration of credit quality but also monitor interest rate movements.

Besides, these funds provide diversification across a wide array of instruments, companies and sectors. While your investments in fixed deposits only fetch you interest income, your investments in debt funds also benefit from the price appreciation of underlying instruments.

The short-term turbulence notwithstanding, the open-end debt funds have continued to provide superior returns than company fixed deposits. However, the prices of debt instruments are governed by three kinds of risks - credit risk, liquidity risk and interest rate risk.

While, the first two risks are more company specific and are closely linked, the interest rate risk is governed by macroeconomics. While a top rated bond is liquid but susceptible to interest rate risk, poor quality debt would be largely insulated from rate movements but would be extremely difficult to sell.

Thus, a fund may be trapped in the event of a sudden redemption. Besides risks, portfolio maturity decides the returns from bond funds. Simply put, it tells us the average life of an instrument that a fund holds. Interest rates and bond prices move in opposite direction with greater impact on instruments with longer maturity.

Thus, bond funds with higher average maturity are more susceptible to interest rate gyrations. While different fund managers follow different strategies, investors will have to carefully assess their appetite for risk and choose their pick. Here, we discuss some of the medium-term debt fundsTempleton India Income Fund (TIIF), launched in March '97, has performed steadily with its quality portfolio and aggressive management. Since 1999, the fund changed its strategy to aim at minimising credit and liquidity risks and actively manage interest rate risk.

While the fund had an average maturity of seven years in April 2000 with 50 per cent allocation to government securities (g-secs), it subsequently pruned it to 2.5 years during the times of volatility. Currently, the fund has 89 per cent investments in Triple A rated instruments with an average maturity of 3.97 years. The fund, despite its rising asset base, is well geared to deliver above average returns.

Till date, TIIF has given an annualised return of 13.35 per cent. Sundaram Bond Saver, launched in November '97, is a medium sized fund. It follows a nimble footed strategy but is conservative when it comes to handling interest rate risk. Through its tenure, the fund has maintained around 70 per cent exposure to Triple A rated papers including g-secs. However, the fund has also retained an average 20 per cent exposure to double A and un-rated papers in year 2000. These instruments tend to pay higher interest income for their lower credit quality.

Though the fund has largely maintained a medium term maturity, it moved to longer dated bonds in late 1999 anticipating a decline in interest rates and made smart gains when the rally took off in the first quarter of 2000. The fund has so far yielded a return of 12.79 per cent since launch and currently has a maturity tenor of 4.9 years in line with the stable interest rate outlook.

Prudential ICICI Income Fund, launched in June '98, is the largest sized open-end debt fund with a steady performance. The fund essentially has a AAA quality portfolio (at an average 85 per cent). While PIIF is not as aggressive as TIIF when it comes to average maturity, it has effectively used its gilts exposure to align the portfolio in line with interest rate expectations in the last one year.

While the fund may not offer blockbuster returns to its investors, it offers a quality portfolio with emphasis on steady returns. The fund has posted a reasonable return of 12.27 per cent since launch, which places it in the middle of the return category.

Value Research