Profit from their strong run

With inflation declining and economic growth slowing down, interest rates began to move southward from October 2008. In such a scenario, income funds, which invest in both short- and long-term debt securities issued by the government and corporates, become attractive. At a time when the one-year return from the Sensex (^BSESN : 16632.01 -222.92) was -52 per cent, income funds have given attractive returns over the six-month and one-year horizon (see table). With interest rates likely to soften further, these funds will continue to be attractive for some more time.

How these funds work

Income funds invest in a mix of debt securities: bonds, debentures, government securities, and short-term instruments like commercial papers and repos. Short-term income funds invest in bonds that mature within one year while long-term funds invest in paper having maturity of above a year. While government securities provide safety and liquidity, corporate securities carry more risk but also provide higher returns.

Interest rates and bond prices have an inverse relationship. When interest rates fall, bond yields fall, and bond prices increase. As bond prices go up, the net asset value (NAV) of income funds goes up, leading to better returns. But the reverse happens when interest rates surge. If you are investing in these funds, then you must keep a close eye on the likely direction of interest rates.

The road ahead

Between 2001 and 2003, interest rates fell and income funds did well. But thereafter (until October 2008) as interest rates surged, these funds did not do well.

Will rates fall? So where are interest rates headed? Says Krishnan Sitaraman, head of Crisil Fund Services, Crisil: "The macro-economic scenario points towards a fall in interest rates. With the economy slowing down, the government is trying to provide an impetus to growth through its stimulus packages and the RBI with a series of interest rate cuts. Inflation is no longer a key variable in policymaking as it was five to six months earlier. Now the government is focused on economic growth and stability. With falling interest rates, the yield on corporate bonds will come down and returns from income funds will look good." Expected returns. The returns from income funds are expected to remain attractive for some time. According to Dhirendra Kumar, chief executive, Valueresearch, a fund rating agency, "The economy is expected to remain in bad shape for some time. And with falling inflation, income funds are safely expected to deliver a return of around 6-7 per cent within three to six months. This can translate into an annual return of around 12 per cent."

What should your strategy be?

You could invest in income funds for two reasons: one, as part of your asset allocation to debt, and two, opportunistically (because interest rates are falling).

Asset allocation. If you are investing in income funds for the first reason, then you should start invest regularly. Before you put your money in these funds, you should weigh them against fixed-income products (fixed deposits, PPF, NSC) on criteria such as post-tax return, risk and liquidity. Liquidity is one criteria on which these funds score higher than most fixed-income products.

Moreover, you should allocate your money among all types of funds: short tenure and long tenure, and also higher risk (income funds) and lower risk (gilt funds). That way some part of your portfolio will continue to perform in all kinds of scenario. If you are a more active type of investor, you could increase your weightage towards short-term funds in a rising rate scenario, and towards long-term funds in a falling rate scenario.

Kumar favours investing according to your goals. "Investment decisions should be guided primarily by your own goals. Investors should not get carried away by the opportunistically attractive but volatile income funds. A fall in interest rates might prove rewarding for them. But these are unpredictable times. And interest rates are a function of government decisions and their direction and quantum can't be predicted accurately. So don't decide based on the state of the market, but on the basis of your time horizon and requirement. Do not go by trends or near-term past performance," he says.

Rahul Goswami, co-head, fixed income, ICICI (ICICIBANK.NS : 850.9 -14.6) Prudential Asset Management Company, too, has a similar opinion. "Income funds should always form a part of an individual's asset allocation mix as they are critical in creating a well balanced risk adjusted portfolio."

Before you decide what proportion of your investments should go into long-term and short-term debt funds, understand the risk-return trade-off between the two types of funds. Says Sitaraman: "Long-term income funds offer higher returns when interest rates fall, but they are also more volatile. If interest rates move up, short-term income funds will be less volatile. So a conservative investor should go for short-term income funds while an investor who has a higher degree of risk tolerance might opt for long-term income funds." Adds Goswami:

"The decision regarding whether one should invest for the short term or the long term should depend on your investment objective and liquidity needs."

Opportunistic investment. If you wish to invest opportunistically - to take advantage of the currently declining rates - invest in long-term funds to maximise your gains. Investing in gilt funds would enhance your returns even further. Says Veer Sardesai, a Pune-based financial planner: "If you expect rates to fall further, gilt funds will give you better returns than income funds as they have securities with longer duration." As for timing your investments, he says: "A risk-averse investor may go for income funds, splitting his investments between now and may be a month later, if interest rates appear likely to fall further."

So far if your portfolio consisted of equities only, this appears to be a good time to make debt funds a part of your portfolio as well.

niti.kiran@expressindia.com