Financial advisers have ridden on this mantra for long - equities are for the daredevils and debt for the ultra-safe guys. All that was required of you was to figure out what kind of a person you were and invest accordingly. But the last three years have been an exception to the rules of the game. While equity investors plumbed a deep trough, the risk-averse guys, who blindly put their money in debt funds, have been sleeping soundly, knowing that their funds are not only safe, but are also growing rapidly.

Bond funds have had an excellent run indeed. In the last three years, the average returns of a debt fund were around 14% (See 'Debt Funds Bonanza'). The reasons were simple: when interest rates fall, existing bonds that carry higher interest rates become more attractive. Their prices rise. It is this rise in bond prices that has driven the bond fund rally for the past few years while the equity market was suffering from the effects of an ailing economy and wary sentiment.

The economic slowdown in the last few years meant that industries did not need funds for expansions. Banks were flush with funds and with no place to invest in, they invested largely in the debt market. With the greater inflows, bond prices went up and yields (interest rates) came down. Steady cuts in other key rates like the Cash Reserve Ratio and repo rate added to the bond rally.

But for those who continue to invest blindly in bonds, it may be time to open their eyes.
With the hope of an economic revival round the corner, demand for funds is likely go up. Banks will revert funds to industry and reduce their exposure to the debt markets. Debt funds will no longer be the unexpected jackpot they turned out to be. If interest rates move up, an existing portfolio could see its value deplete. Freshly-issued bonds will carry a higher coupon and will obviously be more sought after than the older bonds. "Debt funds are not going to deliver the kind of returns they have for the past few years," says Rohit Sarin, partner, Client Associates, a wealth management company.

Not everyone seems to think there's reason to be upset. Mutual funds have been quick to realise how interest rate volatility will hit their returns and erode the value of their portfolio. Many have introduced variations to their plain vanilla debt schemes. Dynamic bond funds and floating rate funds are two such variations. But even these may have their limitations.

"There is going to be quite a bit of volatility in interest rates now. While everybody was riding on the low interest rate regime, we realised that interest rates have to stop crashing at some point and we made sure that we have a product that can safeguard against interest rate fluctuations," says Rajiv Anand, head (investments), Standard Chartered Mutual Fund (SCMF). SCMF launched India's first dynamic debt fund in June 2002.

Dynamic bond funds are different from regular income funds in the way they invest. While an income fund balances the proportion of corporate bonds and gilts and their maturity in its portfolio, a dynamic bond fund attempts extreme moves. If the fund manager expects the gilt prices to rally sharply he will invest the entire corpus in gilts. If he expects interest rates to rise, he will divert the cash into short-maturity instruments, which are least affected by interest rate fluctuations.

"Take the instance of Sundaram Select Debt Dynamic Fund, which started in September 2002 with a predominant exposure to top-rated corporate bonds. By April 2003, the fund has completely exited corporate bonds and has been investing in gilts and money market instruments only," says Amit Kumar, research head, Value Research India, a firm that tracks mutual funds. What a dynamic bond fund manager tries to do is time the market to hedge his risks. He may actually be able to generate higher returns with this frequent reshuffling, but there is an equally big risk of his call going wrong. The performance of a dynamic bond fund, therefore, depends on the fund manager's ability to judge the market and take risks.

As of now, there are eight dynamic debt funds in the market with a total corpus of about Rs 2,750 crore under management. "It is almost impossible to take an accurate call on macroeconomic events such as interest rate movements. But the best we can do is invest to meet our goals and let the market do what it wants," says a fund manager who manages a dynamic fund. That's easier said than done.

If interest rates don't fall drastically in the future, the task of a dynamic bond fund manager will become more challenging as there is limited scope for capital appreciation. The fund manager will be under constant pressure to deliver returns associated with the fund's dynamic style of management. These funds may offer some recourse from interest rate fluctuations. But their performance over the last year shows that in a rising interest rate era, they have underperformed the average medium-term bond fund. But when interest rates have fallen, they have done somewhat better. (See 'Dynamic Funds: Aggressive or Regressive?') A rather cynical financial adviser asks: "If fund managers can spot trends early and allocate money accordingly, why can't they do the same for their plain vanilla debt funds? This is just a marketing gimmick!"

Floating rate funds are another variation. A normal bond's price changes with the interest rate. In floating rate papers, the interest rate is adjusted periodically. So floating rate bonds are less volatile and can be used as a hedge in times of rising interest rates. When interest rates move up, a floating rate fund will be the only income fund that protects returns - as its coupon will be set to higher levels.

As interest rates seem to have bottomed out now, fund houses have scrambled to launch floating rate funds. In this year alone, seven floating rate funds have been launched. There is an important caveat investors should keep in mind though. "Most medium-term bonds - the mainstay of an income fund portfolio - have an average maturity of six years. Floating rate funds, even of the long-term variety, have a maturity of one year," warns a mutual fund observer. This means the current lot of floating rate funds can't be an effective hedge for a medium-term bond portfolio.

A long-term floating rate fund and a short-term debt fund both have similar portfolio maturity. According to fund managers, the main reason for this is the absence of sufficient long-term floating rate instruments. This shortage could reduce over time as the government may issue floating rate papers of longer maturity soon. If interest rate fluctuations are your biggest worry, a floating rate fund is the solution.

Despite the impending fate of debt funds, they are still an important investment in your portfolio. "As long as investors put their money in with a long-term view, debt funds should continue to be an important part of their portfolio," says Anand.

Be prepared for rising interest rates and brace yourself for dipping returns. In fact, investing in debt for the short term can actually make you lose money. Even as you read this, mutual funds are probably scratching their heads to come up with newer ways to attract and keep you in the debt market. Just remember to walk in with your eyes open; reality can bite.