With the fear of inflation rising, is it likely that medium-term debt funds might start giving negative returns? If it is time to withdraw from medium-term debt funds, what are the other relatively safe avenues one should explore?
Urmila Dixit, via e-mail
Inflation refers to rise in prices, and reduces the value of money. This means that if prices move up, you can buy less with the same amount of money. High inflation makes bonds less attractive, as inflation eats away a greater part of the returns they generate. Hence bond prices move downward with rising inflation.
Returns from a bond fund come from interest (coupon) as well as from trading of bonds, based on their price variation. Since inflation diminishes bond prices, an existing portfolio of bonds will be hurt by this fall in prices and returns will fall. Thus, an increase in inflation can decrease your returns from a debt fund. You seem to be worried about debt fund returns touching the negative zone. Now, medium-term debt funds can and do give negative returns on some days. Negative returns on a weekly basis are also not uncommon. For the first time in their history, bond funds as a category have given negative returns (-0.13 per cent) over a quarter in January to March 2003.
We, however, assume that negative returns, over the full holding period is what worries you. After all, different types of debt funds have different holding periods and it is the return over this period, which are pertinent. In the case of a medium-term debt fund, the recommended holding period is one year. Over this period, returns can only be negative if the fall in bond prices exceeds the coupon income from the bond. In theory, this is always a possibility. While this has not happened till now and the chance of it happening is remote, it is always a good idea to keep all such possibilities in mind, no matter how unlikely.
If safety of returns is what you are looking for, then remember that no mutual fund assures returns on your investment. So in mutual funds you are always taking some risk in line with the return you aspire to get. You can consider other avenues such as Public Provident Fund or Kisan Vikas Patra. But again, there is a trade off. For example, PPF may give you guaranteed returns of 8 per cent but it is at the cost of liquidity as this investment has a 15-year lock-in.