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B. Venkatesh

IL&FS Bond Fund Short-term Plan (Growth) returned 8 per cent since January 2002. Investors with an appetite for risk can consider small exposures in the fund.

The important factor that investors have to consider is the fund's 77 per cent exposure to corporate bonds. This exposure, which is very high for a short-term fund, alters the risk profile. The reason is that the fund's net asset value (NAV) will depend on the market price of these bonds, which can fluctuate wildly.

The NAV of short-term funds that primarily invest in money market instruments is not based on the market price, but is calculated on an accrual basis (interest earned on a daily basis).

Investing in corporate bonds, no doubt, enables IL&FS fund to generate higher returns than short-term funds that invest in instruments such as T-bills, commercial papers and call market.

The flip side is that the fluctuation in returns is high; the volatility of the change in monthly returns is 22 per cent (volatility of volatility), which is very high for a short-term fund.

The reason for the high fluctuation in NAV returns may be due to the exposure to corporate bonds. The price of these bonds is a function of credit spreads and the price of government bonds of comparable maturity. Thus, the fund is exposed to two risks; fall in government bond prices — which is the trading risk, and the widening of credit spreads — which is the credit-spread risk.

Credit spreads will widen when the market perceives that the likelihood of default by the companies issuing the bonds has increased. With credit spreads and bond yields having fallen sharply in the last two years, the case for widening of spreads and rise in bond yields is high.

That said, the rally in short-term bonds has been lower than in medium-term and long-term bonds. Should market players buy more short-term bonds, their prices will move up, and so will the fund's NAV.

If bond prices remain at the current levels, investors can expect a return of around 5.5-6 per cent per annum, which is the average yield to maturity of short-term bonds; this return will come from the interest payments that the fund will get because of holding such bonds till maturity. The risk of the downside is, of course, high.

The possibility of some appreciation in short-term bonds, on the one hand, and the declining bank deposit rates, on the other, makes this fund a fairly good investment for risk-seeking investors. The NAV of the growth option is Rs 10.89 per unit.

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