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| You may have heard this a hundred times before, but here we go again: prudent and intelligent asset allocation is indeed the crux of investing. The pros say it doesn't quite matter what securities you choose. As long you stay invested in an asset class which is appreciating, you'll make money. In the last three years, debt funds had an exciting run on the back of a sustained fall in interest rates. Result: even the worst performing debt fund posted returns in excess of 10 per cent. To recall, in February 2000 when the Sensex touched a peak of 6150, all equity funds outperformed the index with returns in excess of 40 per cent annualised . So it did not really matter which fund you were into. You would have made money by simply choosing the right type of fund. |
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| So which asset class will outshine others this year? In the last three years ending June 30, 2003, plain vanilla debt funds returned 13.29 per cent, outpacing equity diversified funds which actually lost 2.46 per cent in value. However, in the last three months, equities have looked up with the Sensex touching 3750 levels. As a result, equity funds posted returns of 26.31 per cent in the quarter ended June 30. |
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| On the contrary, debt funds have been facing increasing volatility. In the first quarter of the current fiscal, debt funds ended up losing 0.86 per cent on an average, wiping out a large part of the gains made earlier. The yield on the benchmark 10-year government security increased from 6.06 per cent in early January to 6.43 per cent by the end of March. During the period, not a single debt fund reported capital appreciation. |
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| In the April-June quarter, however, debt funds made a comeback with average gains of 4.15 per cent. But that's little reason to cheer. Fund managers say that not only are bouts of volatility going to increase, but also debt funds are unlikely to post double-digit returns. "Debt funds will not be able to hand out returns of more than 6.5-7 per cent (this year)," says Rajiv Anand, chief investment officer, Standard Chartered Mutual Fund. |
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| Overall, most fund managers think this year will belong to equities. They say the recent rally in stocks is not temporary and will be sustained. |
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| Does that mean you should put all your money in stock funds? No. Stocks are extremely fickle and in the short-term, volatility is unavoidable. "This year, investors should look at equity mutual funds more favourably than debt funds, but putting all the money is equities can be dangerous," says a financial planner. So some amount of debt is essential to any portfolio. Here are some strategies to make the best of both worlds. |
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| Debt Fuds |
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| The way debt funds are poised today, investors face two challenges: how to preserve capital in case of a trend reversal in interest rates; and how to enhance return given that returns in these funds will fall in line with lower interest rates. |
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| If preserving capital is paramount, then there are the floaters and fixed-maturity plans, though the latter are aimed at big-ticket investors. Floaters or floating rate funds can serve as a good means to hedge interest rate risks and provide a stable income. The distinct feature of a floating rate scheme is that it invests in securities whose interest rates are reset at periodic intervals. This infuses the floating rate scheme with the characteristics of a short-term plan, even though the underlying bonds may mature a few years down the line. A constantly resettable interest rate option effectively reduces the duration of debt instruments. |
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| How does this help? Prices of long-term bonds tend to be more volatile than prices of short-term bonds, but a reset option effectively puts a floor to the decrease in prices caused by rising interest rates. |
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| There are two methods of deciding the level at which the interest rate has to be adjusted. One is to use the average Mumbai inter-bank offer rate (Mibor) over a certain period; and the other is to simply take the Mibor as on the date of repricing the bonds. |
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| Some trade experts say that an estimated 90 per cent of bonds are repriced using the former method. Thus, the return investors will get will be in line with prevailing short-term interest rates. |
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| Again, there are many who question the wisdom of investing in a floating rate bond when there are other alternatives such as bank deposits or short-term mutual funds. However, in case of a sharp spike in interest rates, banks don't pass on the benefit to customers. |
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| On the other hand, under a floating rate scheme, since bonds get repriced every month, it's easy to see why these instruments tend to adapt less painfully to increasing rates. Floating rate bonds may have posted lower returns in the last quarter but their performance in the last six months definitely stands out. |
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| During this period, Templeton Floating Rate Scheme posted returns of 3.07 per cent in the long-term scheme and 2.98 per cent in the short-term scheme. Similarly, HDFC Floating Rate Scheme posted returns of 2.57 per cent. |
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| Compared to this, the return on regular debt funds looks relatively pale at 2.52 per cent. The six-month returns are better for floating rate schemes because of the volatility and the rise in interest rates witnessed in the first three months of the current calendar year. Essentially in volatile times, floaters will tend to do better, while in normal times, these will deliver returns close to those in short-term debt funds. |
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| Another way to contain risk in debt funds is to settle for fixed maturity plans (FMPs), which almost all major mutual funds offer. But the caveat here is that adopt a buy-and-hold strategy. |
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| FMPs attempt to match their maturity with the tenor of securities in the portfolio. You don't have the flexibility of withdrawing money without being charged an early withdrawal penalty. You can't even treat it as a fixed deposit which assures you a pre-determined rate of return for a specified period. |
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| But this newly designed product allows you to choose the maturity period according to your requirement. The fund manager invests in fixed-income securities in a manner which ensures that the fund's holdings mature exactly when the fund is due for redemption. |
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| The fund actually earns regular coupon on its debt and the principal remains intact at the end of the tenure. This reduces, what the experts call, the 'price risk' associated with debt. |
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| This effectively means that investors can protect themselves from any capital loss on maturity. |
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| Enhanced returns |
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| If you like to see better returns than the prevailing rates of interest, the only option is to add a dash of equities to your portfolio. Balanced funds and monthly income plans (MIPs) are good options. |
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| Balanced funds contain just about everything an investor needs. They invest in several asset classes, including stocks, bonds and cash, and stay balanced over time to reflect changes in the economy. Balanced funds aim to achieve a constant asset allocation between equities and bonds over longer periods. |
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| The fact that the fund invests in equity as well as debt means that they will benefit in case either component booms. But not all balanced funds are alike. While some have a strong equity flavour, amounting to almost 60 per cent of their corpus, others such as Children's Benefit Plan and asset allocation funds are skewed towards debt. |
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| MIPs are similar to balanced funds as these also have both debt and equity in their portfolios. However, the relative proportion differs. MIPs have a smaller proportion of their corpus invested in equity, than balanced funds. This is because of the objective of the schemes are different. |
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| MIPs serve the needs of individuals who need regular income. They are ideal investment for persons looking for additional monthly income to supplement their monthly salary, self employed individuals looking for regular returns, or the retired wanting regular monthly income from a one-time investment. To achieve this objective, these funds invest primarily in debt. |
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| A small portion is put in equities to perk up returns. But since these funds have to pay dividends on a monthly basis, they cannot afford to take on too much risk and, hence, even the most aggressive MIPs cap their equity exposure at 20 per cent. |
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| Another option is a dividend yield fund. Currently offered by the Birla mutual fund, this fund actually invests only in stocks which offer good dividend yields. Dividend yield is basically the dividend income as a proportion of the acquisition price of the stock. Fund managers say that a dividend yield should be viewed as a low-risk equity fund. It may be strictly seen as an alternative to debt fund. |
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