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Is there a future for bond funds?

December 20, 2006 09:30 IST
The end of the Cold War between the United States and Russia has made James Bond, and his tribe of spymasters, inconsequential in today's uni-polar world.

Similarly, the spectacular rise of equity markets over the last 3 years has made Bond funds inconsequential in today's growth-oriented market.

Besides this, the rising interest rates during this period have made the matters worse. As interest rates rose, bond prices fell (interest rates and bond prices have an inverse relationship). And hence, fall in the NAVs. Therefore, bond funds gave such poor returns (even negative returns) that they stood no chance against the assured-return products like Post Office, PPF, RBI Tax-free bonds etc.; forget about comparing them with the equity.

So, do Bond funds have any place in our portfolio going forward? Is there any future for the Bond funds or should we give them a decent burial? (As for James Bond's future, you would have to check with the MI6).

Does a Bond fund have a place in our portfolio?

Equity as an asset class has proven to be a much superior product as regards the returns is concerned. But, of course, it comes with a higher risk. Therefore, it will not be prudent to put 100% of one's money in equity.

Secondly, equity requires a longer investment time horizon. In short term, equity markets can be highly volatile. Therefore, for our short-term needs (and certain money kept aside for emergency needs) it will be better if such funds are not invested in equity.

Therefore, howsoever high one's risk appetite may be and howsoever great prospects equity offers, there is definite place for Bond funds in everyone's portfolio.

Only two questions need to be answered i.e. i) how much? and ii) which funds?

How much you should invest in Bond funds will depend on primarily on your time horizon and risk appetite. But generally speaking at least 20-30% of your total money should be in debt instruments and going up to 80-90% for very conservative investors.

As regards which Bonds funds to invest in, the next question 'Is there a future for Bond funds?' will provide the answer.

Is there a future for Bond Funds?

As far as the 'interest income' is concerned, one can today expect comparatively good post-tax returns from a Bond Fund going forward as:

a. The government has progressively reduced the interest rates on PPF, Post Office schemes, etc.
b. It has also discontinued the tax-free RBI bonds
c. The general interest rates in the economy have gone up
d. MFs enjoy a better tax treatment vis-à-vis other debt instruments

However, the threat of rise in interest rates still remains. As long as interest rates remain stable or go down, they will give good returns. But, if interest rise again, it will affect the returns.

Therefore, the future of Bond funds lies in the hand of the RBI Governor. He would, of course, like to keep the interest rates at modest levels, unless the economic situation forces him to stipulate higher rates. The recent hike in CRR will further increase the interest rates.

But the rising interest rate scenario appears to be almost tapering off (there could be some further increase but maybe only marginal). If that be the case and if in the next 6 months to 1 year the interest rates start moving downwards, Bonds funds can give good returns – both interest income + capital appreciation.

If one is willing to take a bet on the interest rates moving downwards, one can invest in Bond and make good returns. But one should be ready to switch out in case the interest rate scenario turns adverse.

As an alternative, we have the Fixed Maturity Funds (Bonds funds which minimize the interest rate risk). Today one can expect a post-tax return of about 7.25 to 7.75% p.a. from 1-2 year Fixed Maturity Plans. The only point is loss of 'anytime liquidity' vis-à-vis the normal Bond funds.

Another option to minimize the interest rate risk is 'Floating Rate' funds. Here the interest moves with the market and hence the impact on the bond prices (and consequently on the NAVs) is minimal. But because it is more liquid vis-à-vis the FMPs, the returns can be comparatively lower. In today's scenario, one can expect a post-tax return of about 6.00-6.25%.

Bonds funds enjoy lower tax vis-à-vis the Bank FDs (and no hassles of TDS too) and hence can be a better option for people in the higher tax-brackets.

One may, therefore, conclude that while Bond is down, it is not out. It still has a place in everyone's portfolio. It will continue to provide stability to one's portfolio and also give consistent returns. And, if interest rates move downwards, it will also deliver good returns.

The author is an investment advisor and can be reached at sanjay.matai@moneycontrol.com

For more on mutual fund investments, log on to www.easymf.com.

Sanjay Matai, Moneycontrol.com