Do SIPs work for debt funds?

In a systematic investment plan (SIP), you get two key benefits. The first is a disciplined approach to investing, by setting aside small sums of money at regular periods. The second is the benefit of not having to time your entry into the market and thus averaging out the cost of your investments.

Investing through the SIP route in equity funds certainly embraces these benefits. But the payoffs in debt funds are not so clear-cut.

Many fund houses sell the SIP option in debt funds as a good substitute to a recurring deposit. Yes, for the ‘discipline’ benefit — putting in sums of money at fixed intervals — the SIP option works well. But what about the second benefit of shielding yourself from volatility?

First, let’s understand the risks when investing in debt funds. Debts funds are subject to volatility depending on the interest rate movements. When interest rates go up, bond prices fall, since new bonds that are issued will carry a higher interest rate than the existing bonds. The reverse happens when interest rates drop — bond prices rise. Interest rates and bond prices are always inversely related.

Thus, the interest rate risk depends on the strategy the fund follows. It is more prominent in funds that adopt a duration strategy. Duration risk is the sensitivity of a bond’s price to interest rate changes. The longer a bond’s duration, the greater is its sensitivity to interest rates changes. In such funds, the duration can be as high as 11 years and as low as two years. In gilt funds, a fund manager is ideally taking a call on the interest rate movements and adjusting the duration of the portfolio to maximise returns. Even in income funds which invest in debt instruments across different yields and durations, the portfolio is altered according to the expectation of the interest rate cycles.

SIP investments are advisable for longer duration funds such as gilt or income funds and not for short-term funds such as liquid or ultra short-term funds.

In the case of accrual-based funds, the fund manager looks for shorter duration corporate bonds that deliver high yields. The focus is to get returns through high accrual of interest on the bonds in the fund’s portfolio. These are less volatile than an income fund or a gilt fund.

These funds generate accrual income by holding the instrument till its maturity. Therefore, there is no interest rate risk. The strategy, by itself, helps beat the volatility in interest rates and here, the SIP route is not viable.

So should you start an SIP now? Usually, an SIP works well in a rising interest rate scenario, when investors can invest more and more units at lower prices.

In the last one year, interest rates have been highly volatile. Till about May last year, we were in a rate cut cycle. Between April 2012 and May 2013, the RBI cut the key policy repo rate by 125 basis points. But after the liquidity-tightening measures introduced by the RBI in July 2013, rates spiked. After September, some of the measures were rolled back, but the key policy repo rate was hiked by 75 basis points.

The RBI appears to have paused for now. While rates are not likely to spike much from here, rate cuts will take a while longer. In the interim, interest rates are bound to be volatile. If you are looking to invest in gilt or income funds, follow the SIP route. Over the next two to three years, as rates fall, investors could gain from the rally in bond prices.

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