With RBI signalling an imminent hike in interest rates, many investors are channeling fresh investments to debt funds, while others are shifting part of equity investment to debt instruments fearing instability in equities. FC Invest guides you which debt fund to pick and what kind of returns you can expect...

With the Reserve Bank of India (RBI) giving clear signals of a possible interest rate hike, investors willing to invest in fixed-income or debt funds will find themselves in a bit of a fix over the kind of schemes they can choose to offset the risk on their investments arising out of higher interest rates.

While in the extreme short term, it may not impact the equity market, a rising rate scenario may affect the equity market adversely over a period of time. So conservative investors from the equity market, too, may shift a part of their wealth from pure equity funds to debt funds only to return when the equity market corrects in order to maximise gains.

Usually, investors with a low-risk appetite invest in debt funds, but often, they take returns from these investments as guaranteed, which is far from reality.

Many investors are unaware of the fact that these funds can also lead to erosion of assets due to interest rate risks associated with them.

With the wholesale price index expected to be in double digits in the first quarter of 2010-2011, inflationary pressure is mounting on interest rates. According to a Dun & Bradstreet report, the prime lending rate (PLR) is expected to increase to around 12.50-13.50 per cent by the end of financial year 2011 from an expected 11-12 per cent by the end of financial year 2010.

Lending rates are expected to surge as an after-effect of the anticipated monetary tightening steps taken by RBI to rein in inflationary pressure.

The yield on 10-year government securities is also expected to incre-ase to 8.3 per cent by the end of fin-ancial year 2011 as high inflation and further increase in policy rates by RBI may dampen sentiments in the G-Sec market.

FC Invest spoke to fund managers and wealth planners to find out the right mix of debt funds at a time when interest rates are expected to go up. Although experts remain divided on the issue of investing in long-term debt funds, there was almost a consensus on three categories of funds that they feel can give good returns to investors.

Liquid funds

These are short-term funds with a tenure of up to 91 days. These funds invest in money market instruments with a maturity of not more than the tenure of the fund. Experts say since they are short-term funds, their exposure to interest rate volatility is minimal and due to higher interest rates, their short-term yields should go up, generating higher returns.

“Investors can look to invest in short-term funds, because these funds have low duration and hence minimal exposure to mark-to-market losses,” said Ganti N Murthy, head of fixed income at Peerless Mutual Fund.

In addition, these funds tend to gain from higher yields due to a rise in interest rates.

Arjun Parthasarthy, head of fixed income with IDFC Mutual Fund, said investors decide where to invest depending on the time horizon of investments.

“If an investor requires liquidity, he should be in liquid funds, because higher interest rates push up short-term rates,” he pointed out.

At present, the average annual return on liquid funds is 3.69 per cent with the top-performing fund giving a return of 5.99 per cent. The returns are expected to be higher if interest rates go up.

Floating rate funds

Floating rate funds invest largely in floating rate securities and, therefore, are better equipped to mitigate the risk of volatile interest rates.

Rakesh Rawal, head of wealth management at Anand Rathi Fin­ancial, said with all the talk of an imminent interest rate hike, short-term floating rate funds can be a good investment option.

Gaurav Mashruwala, a certified financial planner, said although he would not advise investors to make short-term investment decisions in a situation where interest rates look set to go up, floating rate funds are a good option.

Murthy of Peerless Mutual Fund agrees. “Floating rate funds would do well in a rising interest rate re­gime. Also, hybrid funds, which have an exposure to floating-rate ins­truments and have shorter duration, will benefit from rising interest rates,” he said.

At present, the annual average return on short-term floating funds is 4.45 per cent compared with 2.96 per cent return on short-term giltfunds.

Fixed-maturity plans (FMPs)

For investors having an investment horizon of over one year, fixed-maturity plans (FMPs) with 13-15 month maturity can offer a healthy 6.5 per cent to 7 per cent return. Fixed-maturity plans are close-ended funds with fixed maturity. They invest in debt instruments such as commercial papers, certificates of deposit and debentures. Some FMPs also have a small component of equity exposure to boost returns.

Himanshu Kohli, chief executive officer of Client Associates, a wealth management firm, said if one invests in FMPs of over one year tenure at this juncture, he can easily expect a return of close to 7 per cent. “As FMPs are close-ended and are held to maturity, any interest rate hike will not affect returns from such funds,” he added.

Apart from good and virtually guaranteed returns, FMPs are tax-efficient because of the double-indexation benefit they offer.