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They Were Up, Now They are Down

Belying expectations, another rate cut did not materialise in July. This has dampened the spirits of the Bond Bulls and fixed income funds which didn't gain as sharply as they did in all other months this year. But they don't seem to be running out steam. Read more on what happened.

The 9-month strong rally in bond markets finally showed some signs of fatigue in July. While yields dropped to historical levels in anticipation of a further cut in interest rates, it failed to materialise. The central bank officials also talked down bonds in a bid to rein in the runaway prices. Towards the end of the month, some of the debt funds with aggressive investments in sovereign bonds and gilt funds saw a drop in net asset values. Yet, despite the slowdown, debt funds continue to shower investors with impressive returns.

While interest rates are expected to remain soft in the near future, an encore is unlikely. Thus, investors should not enter a bond fund in the hope of earning similar returns and realign their expectations. The lowering of interest rates will eventually bring down fund yields in line with those offered by other fixed income products. The consensus puts the one-year return from debt funds between 9-10 per cent.

Further, with a fast deteriorating economy, the issue of credit quality has again come under sharp focus. Credit quality simply means the ability of the company to pay back money to its investors. Recently, term-lending major IDBI was downgraded from AAA to AA+. And the next in line to face a downgrade was the Non-Convertible Debenture (NCD) issues of TELCO. Thus, investors need to thoroughly scan the portfolio of their debt fund and make sure that the fund manager is not taking undue risk to generate returns. Invest only if you are comfortable with the credit quality of your fund's portfolio! While all lower rated bonds are not necessarily poor quality investments, fund managers also have to exercise extra caution and manage these holdings dexterously.

Medium-Term Funds

Debt Funds
Despite the slowdown in the rally, this category of 36 funds posted an average return of 1.34%. However, there was a wide variance in weekly returns for the month of July as bond prices took a breather. Thus, the one-week return for July 27 was only 0.13% against the one-week return of 0.55% on July 6. With capital gains on a decline for funds with higher gilt investments, funds with reliance on interest income emerged on top. Thus, UTI Bond Fund which was at the bottom of the heap in the last quarter, emerged on top with a one-month return of 1.94%. The fund holds investments only in corporate bonds with a high allocation to lower rated bonds. These papers give higher returns for being lower on credit quality. While there were no losers, Dundee Bond PSU could muster a return of only 0.75%.

Leaders and Laggards in this category

Gilt Funds
While average returns are still impressive, there has been an appreciable slowdown from the May-level of 2.33%. With their investments dedicated to Government Securities, gilt funds are armed with high liquidity and they instantly reflect any changes in the interest rate outlook. Since the much-anticipated rate cut failed to happen, gilt prices came under some selling pressure during the month. Yet, the category ended with a net gain of 1.80%. Chola Gilt Investment topped the charts for July with a return of 2.96%. With its portfolio concentrated at the very short-end of the yield curve, Alliance GSF (long-term) was second with a gain of 2.39%. On the other hand, Escorts Gilt ended the month with a return of only 0.86%.

Leaders and Laggards in this category

Debt with marginal equity
Popularly known as MIPs, these funds invest predominantly in debt instruments while taking up 15 % exposure to equity instruments. However, some funds have been simply staying away from equity to align with investors' risk return spectrum. On the other hand, a few funds have a small equity allocation in their growth option while staying away from the same in dividend options. With a 100% debt portfolio, the savings option of HDFC Children Gift Fund has returned an impressive 1.88-% for July. On the other hand, all MIPs with an equity component have landed at the bottom of the returns table, albeit with no losses. Templeton MIP (G), with a 6.64% allocation to equities on June 30 has delivered a return of only 0.71%.

Leaders and Laggards in this category

Short-Term Funds

Cash Funds
Short-term funds are good substitutes for bank deposits if you are looking at a parking lot for your cash surplus. With a very short-term maturity (typically under one-year) and high cash component, they are largely insulated from interest rate gyrations. For the month gone-by, the category returned 0.6873% with Dundee Liquidity topping with 0.8845%.

Leaders and Laggards in this category

Gilt Funds
While their investment mandate is ditto as that for long-term gilt funds, this class invests in Government securities with short- term maturity. Thus, they are less volatile than their long-term counterparts. Alliance GSF tops its category with a return of 1.66% on the back of a very short-term portfolio maturity of 1.8 years. Interestingly, its long-term counterpart is also invested in the same security (12.50% GOI 2004).

Leaders and Laggards in this category

Debt-Speciality
This non-comparable category comprises of all funds whose investments are linked to certain maturity. These funds buy into securities maturing on a particular date and hold on till maturity. Thus, these funds insulate investments from interest rate volatility and offer an implicit assured return.

Leaders and Laggards in this category