Steer clear of income schemes

Movement of interest rates impacts the net asset value of debt schemes the most.

Investors of income funds are not a happy lot. Four years ago, these debt-oriented schemes had clocked superb double-digit returns.

Since then, returns have been steadily declining, which is also reflected by the dwindling AUMs (Assets Under Management) of this category.

Parallely, the AUMs of equity schemes have been growing phenemonally, which is natural considering the bull run in the stock market.

Clearly there is an euphoria and glamour around equity schemes and it is an inopportune time to talk about debt schemes. But it is never a wrong time to understand the dynamics of an asset class and the mutual fund schemes whose portfolio comprises those underlying assets.

Debt-oriented schemes invest in debt securities, which can be government securities or sovereigns, debentures issued by corporates, state government and the central government, treasury bills, fixed deposits of banks, commercial papers, certificate of deposits etc.

These instruments are characterised by a few factors:

Fixed Interest Rate: In some cases, the interest rate is pegged to a known benchmark and could vary and are called floating rate instruments.

Fixed Maturity: They have a fixed date of maturity.

Since the interest rate and maturity period is known, the market price can be determined based on prevailing yields in the market.

A debt"�oriented scheme has a pool of debt instruments in its portfolio. In an equity-oriented scheme, the prices of the stocks in the portfolio goes up if the Sensex/Nifty moves northward and the NAV (Net Asset Value) of the scheme moves in tandem.

Similarly, the movement in the NAV of a debt portfolio moves with asset prices of these debt instruments. The difficult part is to understand how these prices of debt instruments move.

The biggest factor that impacts the assets and thereby the NAV of the debt scheme is the movement of interest rates in the country. The gains and losses in the NAV of these schemes move inversely against the movement of the interest rates.

To understand this, we need to understand the relationship between the price and yield of a debt instrument. Here is an example to illustrate that:

Lets say Zee subscribes to a government bond for Rs1 lakh. The price is Rs 100 per bond and so he receives 1000 bonds. The interest rate is 8 per cent for six years, which is payable annually. After six years, the government will pay back his Rs 1 lakh and shall pay him an interest of Rs 8000 every year. We will assume that these bonds are listed and retradeable.

Let us suppose that the government has reduced the interest rate on similar bonds of six years tenure at 6.5 per cent. The obvious fallout for Zee will be that he will be glad that he has locked in the rates at 8 per cent. But, there is one more benefit.

Since there has been a downward trend in the interest rates, he can make a killing by selling his bonds. How? Since the new lot of RBI bonds are giving 6.5 per cent, his Rs 100 bonds will get realigned to new rates. If he wants, he can sell and transfer those bonds for Rs 105 per bond (Rs 105 is the price at which the bond will yield at 6.5 per cent)and make a cool profit of Rs 5 per bond.

Similarly had the interest moved up and fresh bonds issued at 9 per cent, the price would have gone down to say Rs 96 per bond to realign with the prevailing rates.

The price of his bond went up when the yield fell and went down when the yield rose. This is a very basic explanation of how money appreciates in a debt scheme. In reality, there are many complex factors, which interplay and mark your profits or loss in the instruments and schemes.

But, the question would arise on why debt fund managers are in the depths of despair. Interest rates have been singularly rising in the last four years. Naturally the value of their existing stocks have been falling drastically. They had to be extraordinarily nimble to manage funds in bearish markets.

What makes the interest rates rise or fall is a very complex question that will need a deeper understanding of global and domestic financial systems. Currently, we can say that the interest rates are going to be volatile for the next few months.

Well, you might be wondering what is the moot point of this outburst against the fortunes of income schemes. The point is to steer clear of them for at least the next quarter till there is an outlook of optimism.

In the category of debt funds, gilt schemes are the most volatile. One can invest in liquid schemes, which in turn invest in debt instruments of lower maturity and are insulated to a certain degree against the movement in interest rates for short-term parking. Short"�term floating rate funds can also be considered as a relatively safer bet.

If you want tax efficient returns then Fixed Maturity Plans (FMP) are unbeatable. Currently, a 16-month FMP is indicating a pretax yield of 9.15 per cent, which works out to about 8.7 per cent post-tax, considering double indexation benefit. Banks have also upped their deposit rates and are giving about 9 per cent for about 3.5 years of deposits.

The government-administered small savings are giving pretax 8 per cent return in different products like the Nsc's KVP. RBI Bonds are yielding 8 per cent. Senior citizens can earn up to 9 per cent in the senior citizen's scheme. These products can also be considered after giving due merit to its government guarantee and tax incidence.

(The writer is the Head of Mutual Funds, Derivium Capital & Securities Pvt Ltd.)