Gilt medium-&-long-term and income funds were the debt categories that saw the most erosion in returns in July, a month when both short-term and long-term yields shot up following the central bank’s measures to tighten liquidity to stem the rupee?s fall against the dollar.

Both categories saw average category returns of -3.7% and -2.5%, respectively, in July. Short-term bond funds also took a hit, with returns of -1.4%. Liquid funds emerged as top performers with positive returns of 0.5%.

?Higher-duration bond funds are the most sensitive to interest rate movements, which is why long-term gilt and income funds suffered the most,? said Dhurva Chatterji, senior investment consultant, Morningstar India.

For June, the average maturity period for Morningstar India Long-term Government Bond funds was about 10.4 years, while that for Intermediate Bond funds (which includes income funds) was around six years.

Short-term bond funds suffered despite having a relatively shorter average maturity profile of about two years owing to the sharp jump in short term rates.

?The impact would have been higher had fund managers not been holding some cash and cash equivalents,? said Dwijendra Srivastava, head, fixed income, Sundaram Asset Management.

The yield on benchmark 10-year bonds rose about 70 bps to 8.169% at the end of July from 7.463% a month ago. One-year corporate bond yields for AAA papers rose 100 bps to 9.7615% from 8.728% in the same period.

The trailing one-year returns at the end of May 2013 for intermediate and long-term bond & gilt funds stood at 13-14% (on average), which has come down to 6-7% levels at the end of July, according to Chatterji. He believes that those invested in duration bond funds should temper their returns expectations in 2013 and be prepared for some volatility.

According to him, those with a higher risk appetite can consider duration funds like dynamic bond funds, while those with a low risk appetite should consider ultra short-term and short-term bond funds. Investors could also look at fixed-maturity plans given the spike in short-term interest rates, he added.

On July 16, the sharp spike in short-term bond yields led to panic selling in liquid schemes of mutual funds. Returns of some income and gilt medium-&-long-term debt funds declined about 4% that day.

Bond prices and yields typically share an inverse relationship; if yields rise, bond prices fall and if yields fall, bond prices rise. The fall in bond prices affects the net asset value of debt schemes, especially those that have a mandate to invest in longer-duration papers of between five and seven years, according to experts.