There is a general perception (or shall we say a common misconception?) that only equity markets and related investments are volatile while fixed income/debt products give stable fixed returns. While it is true that debt funds seek to protect your capital, they are subject to interest rate risk. What it exactly means is that while one is sure that his or her investment is reasonably safe and is unlikely to fall below the principal over the long term, there is no guarantee on how much you would earn on it. It could be as low as 3-4 % pa or a 10 % plus annual return, depending on the prevailing interest rate scenario. Even during a secular downtrend or an uptrend in interest rates, there could be periods of interim volatility which could affect the returns. Let us understand this in detail-

• Mr. A expects the interest rates to fall based on the economic indicators, and hence to benefit  from the falling rates, invests in a long term debt fund, since bond prices are known to have a inverse relationship with interest rates. But what if this doesn’t happen or the opposite of this happens? If the interest rates rise, the bond prices will fall and there will be a capital loss which when subtracted from the interest income, would significantly reduce the returns.

This is where flexible debt/dynamic bond/flexible income plans assume significance.

These are debt funds where the fund manager invests in a mix of debt papers of different tenors and varying maturities and has the flexibility to change the allocation anytime. If the market conditions are uncertain or bearish, these funds can have the significant chunk- even up to 100% in money markets or up to 100 % in debt market during a bullish interest rate scenario.

This active management of debt has really worked as can be seen in the table below which shows the returns generated by the leading funds in this category –

Source : Bajaj Capital Ltd-Returns as on 26 June 2013

The added fact that the investor does not undertake any personal tax liability even though the fund may frequently switch between different debt options adds to the attractiveness of these funds. One can consider investing in these as part of the fixed income allocation in one’s portfolio.

Disclaimer : The views expressed in this article are solely of the author and for informative purposes and do not constitute or indicate any kind of investment recommendation.