Here's why debt funds should form an integral part of your investment portfolio

Debt investments should form an integral part of any investment portfolio for two major reasons: One for stable returns, and second, to spread across risks so that there is a cushion when rates fall and equities tank.

In addition to equities, prudent fund managers often shuffle portfolios across varying maturities in debt, depending upon market conditions.

Today, in the Indian context, interest rates are seen downward in the longer time frame, though near-term could be steady to firmer.

There are, however, inherent risks involved if two facts – volatility and time frame – are not taken into consideration.

Volatility: It's a factor that leads to a sharp rise or fall in the prices of debt instruments when interest rates dip or rise respectively. Interest rates and bond prices are inversely proportional, meaning if interest rates drop, bond prices soar, and the reverse occurs when interest rates rise.

Time frame: Is the period for which funds are parked or invested. One can even invest in debt for a period ranging between a day and as long as 30 years.

Broadly speaking, investment options in debt can be divided into short, medium or accrual and long-term debts.

Short-term funds: These are liquid funds where one can earn returns of 200-250 basis points above the current savings bank rates of 4-6%.

Liquid funds, as the name suggests, are as good as any saving account, the only difference being one would perhaps need a day or two for the funds to come into the kitty. It has been often observed many savers let funds idle in bank savings as a protection for future eventuality or emergency, little knowing that liquid funds offer the same benefit and even earn a higher rate than savings.

The instruments in which such funds invest are short-term government papers like treasury bills and other money market instruments of shorter maturities of three months or less.

There are cases where smart investors park their salaries in such instruments till their regular outflows like SIPs, home loan installments, insurance premiums, etc., begin. For example, if your home loan EMIs are slated for the tenth of every month and the salary is credited to the account on the first of every month, by parking the same funds in liquid funds, you stand to enhance your interest accruals by at least 200 basis points for that nine-day period instead of the 4-6% earned in a savings account.

Medium term/accrual schemes: These schemes typically invest in government bonds and corporate bonds while maintaining the average maturity of around 3-5 years. The corporate bonds in this case need not necessarily be AAA rated bonds, but a notch or two lower as they offer higher returns to the fund.

The view of the investor, on the other hand, is one of a shorter duration. Three years or more is recommended for tax exemptions and typically syncs with the investors' need for future requirements.

The reason why fund managers recommend investments with a duration of three years and above is that the returns are as good as tax-free. Such funds are also called accrual funds. These funds maintain a higher yield to maturity (YTM) through exposure to sub-AAA assets while AAA assets of 5-10 year maturity are taken as a hedge to provide the benefit of price appreciation should interest rates fall.

Higher the accruals, lower will the corporate bond maturities be, and therefore, lower the interest rate risk.

For example, if the interest rate view of a fund manager is that of a softening trend, in such a case, besides earning the interest rates or coupon on the bonds, the portfolio would appreciate if the view holds good.

However, if the view held turns wrong, which is, the rates firm up, prices of underlying securities begin to slide. This is when fund managers recommend systematic transfers to average out the costs of the underlying.

Long-term investments: The longer the duration, the more will be the volatility in the near-term, but returns get adjusted with time if rates are stable or easing. In such a case, the key driver of returns is the fluctuation in interest rates. Given the macroeconomic fundamentals and that long-term interest rates are poised downward, long-term investors stand to gain from price appreciation of the underlying securities. However, there could be intermittent blips where the returns could be lower.

Last year, up to December, the yield on a ten-year government bond was broadly flat year on year at 7.75%, returning a net of 7% in the category. However, at the shorter end, 2-year returns were at around 11% and 3-year at 9%.

Currently, the 10-year yield is 7.75%, CPI is at 5.40% and repo rate is at 6.75%, which implies that a rise in prices of the underlying is a possibility while the downside risk remains limited.

Such funds invest only in AAA corporate bonds and government securities for optimum returns and safety. Therefore, for all long-term needs, this category should be looked at.

(Next week: Planning retirement in debt investments)