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Almost 80 per cent of my investible funds are in stocks/diversified equity funds. To diversify, I invested in January 2004 in Birla Gilt Plus & HDFC Gilt Fund.

However, the NAVs were declining and I liquidated the investment in September 2004. I feel the strong need to invest in bond/gilt funds to diversify my portfolio. Kindly suggest funds where capital is protected and 8-10 per cent annual return can be expected over a period of two-three years.

Is there any correlation between the stock market and the bond/gilt market ? Are NAVs of bond/gilt funds going down because stock market is booming? Kindly clarify.

S. P. Patkar

Mumbai

You are right in trying to diversify your portfolio so that you have a more balanced asset allocation. But you may have to tone down your return expectations, if you wish to invest in debt-oriented funds. Mutual funds, as a rule, do not offer capital protection and offer only market-linked returns that tend to vary, depending on the interest rate environment.

Returns of 8-10 per cent a year that you expect may not be possible from debt mutual funds for now. If you are really keen on capital protection and fixed returns, you can consider shifting part of your portfolio to the Public Provident Fund, which continue to offer a 8 per cent tax-free return. However, this will involve locking in your money for a considerable period of time.

If you cannot afford to do this, then you can consider debt funds. The returns from debt funds are dependent on the instruments they invest in and trends in interest rates. Among the debt funds, liquid funds offer the highest degree of protection for your capital.

Returns from these funds would be in the 4-5 per cent range. Short-term funds may offer slightly higher returns than these(say 5-5.5 per cent), with almost a similar risk profile. These would be the funds most suited to investors who would not like to assume risk to their capital.

Long-term debt funds and gilt funds can offer higher returns, with high liquidity. However, the value of your investments can undergo sharp swings over a period of time depending on trends in market interest rates. Here is why:

Debt and gilt funds usually invest in long-term borrowings of the government or corporate issuers at fixed rates of interest. These funds earn their return from two avenues — the interest payments that they receive from bonds/gilts and the fluctuations in the market price of their holdings. If interest rates fall, the prices of the bonds and gilts that these funds hold appreciate in value, pushing up the NAV of these funds. (This is because as interest rates fall, buyers of bonds are willing to pay a higher price for bonds that carry a higher interest rate).

This is what happened between 1999-2003 and this enabled debt funds and gilt funds earned high returns of between 14-16 per cent a year. But with interest rates bottoming out and beginning to rise since mid 2003, the NAVs of bond and gilt funds have fallen, resulting in a capital loss for investors who entered the funds in a falling rate environment.

Going forward, gilt and long-term bond funds may begin to turn in higher returns than they have in 2004. But their NAV movements will continue to depend on the direction of interest rates and there can be no assurance that your capital will be protected.

At times, both bond and equity funds have delivered high returns. There have, however, been times when they have diverged. There is an indirect linkage between interest rates and the stock market. Bonds and stocks do compete as alternative channels for fund flows from investors.

However, there are a host of other factors that influence domestic stock and bond market returns, which distort their relationship with each other. Therefore, a booming stock market does not automatically mean a depressed bond market or vice versa.

(Queries may be e-mailed to mf@thehindu.co.in, or sent by post to Business Line, 859/860 Anna Salai, Chennai 600002.)

Aarati Krishnan

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