Should debt funds be in your portfolio?

Interest rates and debt security yields have reached historic lows and debt funds "" once offering both safety and substantial capital appreciation "" are hardly offering any returns to their investors. It certainly looks as if debt funds have run out of steam.

However, Sandesh Kirkire, debt fund manager with Kotak Mahindra Mutual Fund, offers some compelling reasons why debt funds should still find a place in any prudent investor's portfolio.

According to Kirkire, yields on debt securities are low and any rise in the yields is likely to be gradual. One reason for this is excess liquidity. Further investments in debt funds would normally not lead to a capital loss, unless there is a credit default; the holding period of the investment could however prolong.

In a rising interest rate scenario, higher reinvestment rates and active management of portfolio are likely to enhance portfolio returns.

Asset allocation is as critical for investors today, when interest rates may stabilise or even move up, as it was when interest rates were in a free fall.

However, there will be a gradual rise in interest rates. A comfortable liquidity condition, moderate inflation and integration of Indian capital markets with global capital markets will not allow domestic interest rates to spike. Any rise is likely to be gradual.

Kirkire feels that coupon and predetermined maturity are the saviours. "It is the realisation of regular coupons and capital at the end of a predefined period, which distinguishes debt from equity as an asset class. When interest rates are rising, the increase in accrual compensates for capital loss on the portfolio of debt securities."

Hence, unless there is a credit default, debt funds will normally not give negative returns, though the holding period may have to prolong. Historically, interest rates normally rise in an improving economy.

"And improving economy increases the chances of credit up-gradation, thus reducing the chances of credit default," reasons Kirkire.

Now the third reason "" reinvestment rates, will augment portfolio returns: If interest rates rise, this will result in higher reinvestment rates for coupons and for maturing investments in the portfolio.

This will help compensate, at least partially, the capital loss on the portfolio arising from the decrease in security value owing to a rise in interest rates.

Over a period of time, this reinvestment element becomes sizeable and augments returns in the portfolio. This is exemplified in the following example :

If the duration of a portfolio is three years, the running yield is 5.5 per cent a year.

The running yield post expenses (1 per cent p.a.) and post tax (dividend distribution tax of 12.8125 per cent) is 3.92 per cent a year.

There is no active management of the fund, and the hike in interest rates happens immediately. Then the post tax annualised returns will be as follows:

So, even if the interest rate goes up by 1 per cent, post-tax return of a passive portfolio over two years will be 3.92 per cent, which will still be higher than the post-tax returns from comparable fixed deposits.

"The above example assumes a passively managed portfolio," says Kirkire, adding that in reality, markets undergo a lot of price fluctuations, offering continuous opportunities to the fund manager to enhance returns by actively managing funds.

"If interest rates go up, the price of a security goes down. The degree of fall in price depends on the maturity of the security. The lower the maturity of a security, the lower will be the fall in its price and, hence, the capital loss will be lower. And vice versa. An active fund manager will endeavour to invest more in short maturity securities when rates are expected to move up and invest more in long maturities when rates are expected to go down," said Kirkire.

Finally, asset allocation. Investments are, after all, all about optimising returns to meet your needs and aspirations, based on your risk appetite.

Asset allocation helps reduce risk and improves return potential. Not all investments appreciate, or depreciate in the same proportion, at the same time.

By diversifying your investments across uncorrelated or negatively correlated asset classes or investment instruments, you can reduce the risk involved in misjudging the asset class or investment instruments.

On the whole, over the last 10 years, if someone had diversified the investments between debt and equity (Equity investments being always higher than 50 per cent), the returns from a diversified portfolio will have been higher than those from dedicated debt or dedicated equity portfolios. This is exemplified in the following example:

If someone had invested in a private sector mutual fund on 12-01-1994, the returns as on 30-01-2004 would have been as follows:

The need for asset allocation is insensitive to market conditions and should be based purely on unique financial circumstances of an investor.

In conclusion, Kirkire says, "In your asset allocation, irrespective of the interest rate outlook, let asset class be determined by your needs; and let investment instruments within each asset class be a function of your investment horizon.

For example, if you need your funds at the end of next two years, you may do well to invest the same in long-term debt schemes such as Kotak Dynamic Income Scheme, or in a debt scheme, which invests only a small portion of the portfolio in equity and related instruments such as Kotak Income Plus.

"Your money that you can't put at risk must go to an appropriate debt scheme."