Debt funds -- Increasing risk

Suresh Krishnamurthy

DEBT funds have delivered attractive returns to investors over the last 18 months. Among debt funds, gilt funds are even more attractive. In fact, some of the funds appreciated more than 20 per cent -- something even equity funds would be proud of.

Investors now have to be wary. Yes, many investors would now be aware that past returns are not sustainable. The yield on a 10-year government security is now less than 8.5 per cent, and corporate bonds are unlikely to offer more than 1.5 per cent over government securities.

Importantly, it is not only a question of lower returns. The risk that interest rates would rise and, therefore, returns would be much lower than what the market now offers is quite high. The risks are also higher because most income and gilt funds continue to maintain higher than average portfolio maturity. In addition, the government's fiscal balances add to the risk of a spike in interest rates.

However, fund managers have neither indicated that they would reduce the average portfolio maturity over the next few months nor have they drawn the attention of investors to the risk involved.

In this backdrop, if interest rates do rise, investors may have to hold the units for much longer to get returns around the level indicated by the markets now. This is scary because some gilt funds now have average portfolio maturity in excess of five years.

In this situation, investors in long-term gilt funds would be better off substantially reducing their exposures to the funds and switch to short-term gilt funds. The difference between the yield on a five-year and a one-year government security is now less than 30 basis points.

In addition, investing in a one-year security comes with much lower risk. In investments in income funds, too, it may be better to reduce exposures, especially if you have commitments in the course of the next two years. Being locked in to fixed-maturity investment options, such as term deposits, now appears to be a risk-minimising strategy.