Pensioners or savers thinking of a switch often compare the bank FD returns available to them today with the past one-year or three-year returns of hybrid or debt funds. Past returns of debt funds can, however, be a poor guide to the future.
Taking stock today, one- and three-year returns on long-term debt-fund categories (gilt funds, income funds, dynamic bond funds) are in the 9-11 per cent plus range, while returns on short-term debt funds (short-term, ultra short-term, liquid funds) are in the 6-8 per cent range. But it would be risky to jump into long-term funds expecting a repeat of those high returns.
Long-term debt funds make their returns more from interest-rate moves in the economy than from the interest receipts (accrual) on the bonds they hold. In the last three years, with the RBI's policy rates plummeting by 200 basis points (8 per cent to 6 per cent) and the yield on the 10-year government security falling by over 250 basis points (9 per cent to 6.5 per cent), the prices of the long-term bonds and G-secs have appreciated sharply, helping these funds earn bumper returns. Short-term debt funds, in contrast, have seen their returns fall as they earn the bulk of their returns from interest rather than capital gains.
But over the next one to three years, as we are close to the bottom of this rate cycle, the situation could turn upside down. Market interest rates, which are already poised at 6.5 per cent, may fall just a bit, wriggle sideways or even head up. This will reduce the returns on all the categories of long-term debt funds while returns on short-term debt funds may look relatively better.
This is why investors jumping from bank FDs to debt funds need to choose their debt category based on their risk profile, rather than past returns. If avoiding volatility in returns is your top objective, short term, ultra short-term and liquid funds are your best bet, even if their returns appear lower today.