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It's a repeat of 2000 as investors pour crores in bond funds

While returns are a scorcher, define your goals before choosing the right bond fund

Bond funds are on fire, literally! The Value Research category of medium-term debt funds has posted a one-month simple return of 1.73% while the three-month return is an impressive 3.37%. Government security or gilt funds, with their longer-dated portfolios, are a scorcher with the returns in May at 2.33%. With the other asset class (read equity) in doldrums, money is pouring in bond funds. This includes some investors, who are still nursing the bruises of 2000 and are trying to recoup their losses on equity investments. In the last two months ended May, investors have pumped in an estimated Rs 3,800 crore in debt funds while gilt funds have seen an inflow of over Rs 500 crore. Who needs equity when bond funds can generate an annualised return of 15% or more?

Yet, the current investor penchant for bond funds has an uncanny resemblance with the tech rush witnessed in early 2000. Then, tech funds had garnered over Rs 2,500 crore in a matter of two months but soon plummeted to abysmal levels. "It's a repeat of February 2000 - only debt funds have replaced tech funds with every distributor aggressively selling them. While retail investors are choosing bond funds, some high networth and suave investors are opting for gilt funds,'' says a senior official at Prudential-ICICI AMC, which manages the largest open-end bond fund.

However, with herd mentality on display, a re-run of the past could well be in the offing where a couple of days' downward movement can mar your returns. What is more, most investors are given to believe that bond investments are virtually risk-free and returns can only move up, which, needless to say is humbug. Bonds, like any other asset class, are volatile instruments and are sensitive to such diverse events as an oil price hike to a large auction of government securities. Already, the FITCH downgrade last week saw bonds lose value and NAVs of debt funds dipped marginally. Last year, medium-term bond funds had lost a quarter of a per cent when interest rates were hiked in July.

Thus, it is important that investors are not blinded in pursuit of earning a fast buck. Bonds have already run up sharply in the past couple of months and any mishap at these levels can see a swift fall in prices. With most debt funds heavily invested in government securities (30%+), the risk of loss is greater since these instruments are the most susceptible to interest rate changes.

Surely, returns from debt mutual funds are fraught with their own set of risks. Hence, it is important that investors should invest for the long-term with clearly defined goals. For instance, if you are planning to park your investments for a 3-4 months, opt for a liquid fund that carries minimal risk. Gilt funds are ideal if you plan to stay invested for the long term since they fall in the high-risk, high return category. Else, you could again be in for a disappointment!