Debt funds have been the favourite with investors in the last three years. Shell-shocked by the devastating fall in equity values, and the concurrent appreciation in debt funds, investors have been compelled to take a serious look at this genre.

The popularity of debt funds has been growing phenomenally since 2000, when they started yielding exceptional returns riding high on soft interest rates. Till last year, returns above 15 per cent were not uncommon.

In fact, gilt funds gave returns in excess of 20 per cent, stunning investors.

When seen in the light of falling deposit rates, where most of the retail money finds its place, debt funds appeared too good to be true.

However, a floundering domestic economy and the move by central banks around the globe to cut interest rates to spur growth, only meant that the debt market rally continued unabated and debt funds gave superb returns.

Even though incremental cuts and the gains therein came with its fair share of volatility, the positive direction kept the domestic market upbeat.

Now what? As rates continue to head lower, it's Baye's theorem which is adding to the number of sceptics on bond street.

Every time rates head lower, higher is the overall probability of a reversal, or lower the probability of it falling further. Although the consensus is still that rates will remain stable with a soft bias, the nervousness is evident in the way the market reacted to the Credit Policy last week.

Despite a 25 basis points cut in bank rate and the cash reserve ratio, which was broadly in line with market expectations, yields inched up as the price of government securities plunged.

Reason: the market was not convinced about the sustainability of rate cuts. Even though the RBI governor reiterated his soft interest rate bias, there is an underlying tension over whether the RBI would maintain this outlook in future.

"On balance of probabilities, given normal conditions and overall stability in macroeconomic environment, in view of the several structural constraints, the present nominal and real interest rates are relatively low."

"There may not be significant potential for further sizeable downward movement in interest rates," the RBI statement said. This apart, the market is also interpreting the central bank's decision to keep repo rates unchanged as a conscious effort to set a floor for interest rates.

In the last two years, the RBI's reasoning for rates cuts has been diluted from one to propel growth by providing easy credit during recessionary times, to that of boosting confidence.

Given the ineffectiveness of the policy in spurring growth though increased investments, economists have been questioning the wisdom in cutting rates further.

Given this background, the only factor that could drive the RBI to cut rates could be a continued rate cut by other central banks.

"If the Federal Reserve and other central banks continue to cut rates to provide a boost to their economies, it may necessitate a further cut in domestic interest rates," says Milind Nadurkar, debt fund manager, Sun F&C Mutual Fund.

Otherwise a further cut in rates looks unlikely, agree most experts. Now, what are the possibilities of a reversal? The key factor is inflation and the strength of the rupee.

Inflation has shot up from 2.8 per cent in October to 6.47 per cent currently. If this trend continues the RBI may be forced to hike rates in order to contain inflation.

However, the composition of inflation suggests there is little cause for concern. Inflation in the recent months has been influenced by higher oil prices, and if one strips off petroleum, edible oil and mineral oils, core inflation is around 2.5 per cent.

"We expect inflation to come down and the composition of inflation gives one confidence that it will come down," said the RBI governor in an interview with Business Standard.

That's pretty much what the market players also believe. "There is no reason to believe that inflation will remain high. It should fall under five per cent by the end of this quarter," says Nadurkar.

Things are looking up. "Oil prices have started easing and with the truckers strike over, we expect inflation numbers to be lower going forward," adds Nadkumar Surti, debt fund manager, JM Mutual Fund.

The other factor that could possibly lead to a rate hike is a depreciation in the rupee.

Though there is not much reason to believe that the rupee's value will fall given the ample domestic liquidity, RBI's warning to corporates on their unhedged positions in the foreign exchange market is causing some anxiety.

Even though the RBI governor has stated categorically that the warning was only to remind corporates to be prudent, there seems to be an underlying concern that the bull run of the rupee may not last long.

Some market players believe that the redemption of the $4 billion Resurgent India Bonds could put some pressure on the rupee in the short-term.

But considering that the government has been prepaying its government borrowings on the back of strong forex reserves ($77 billion), that may not make much difference.

Further, if the dollar continues to weaken against all major currencies, the rupee could possibly remain strong. For the next three to six months the consensus is that the market will be rangebound with yields oscillating between 5.75 to 6.15 per cent. That's assuming inflation stays under control.

On the whole, debt fund managers are not exactly pessimistic, but the fear does seem to be creeping in. They are candid in their admission that debt funds will not be able to replicate their past performance.

But what they fail to say openly is how bad could it really get. Here is an approximation.

"If interest rates were to go up by one per cent, a portfolio with a duration of five years would suffer a loss of five per cent," says Nandurkar.

The current yields on an average fund portfolio hovers around six per cent. So net-net, an average fund will end up with a no gain, no loss situation if interest rates were to go up by one per cent. But that's a highly pessimistic scenario.

On an annualised basis, debt funds are expected to give returns of around 6-6.5 per cent this year. Last quarter's performance was miserable. It was the first quarter when not a single plain vanilla debt fund managed to be on positive territory.

On an average medium-term debt funds lost 0.86 per cent on an average. "Last quarter's volatility was due to exceptional circumstances like war fears and associated risks. This quarter should be better," says Surti.

However, fund managers do not expect major gains even in this quarter. They expect the quarter to end with a gain of around 1.5 per cent.

Says Milind Nandurkar: "Fund managers will have to shift from trading in gilts and focus on coupon income for reliable returns. Since the possibility of capital appreciation is capped, the focus will be on gaining income."

That means nothing more than the prevailing market rates after accounting for expenses.

Given the higher risk associated with longer maturity bonds, fund managers are moving towards medium and shorter maturity bonds. Most fund managers have reduced their portfolio maturity to play on the side of caution.

Currently, most funds have an average portfolio maturity of around five years. This is both to minimise the impact of adverse movements in rates as well as to make most of the attractive yields in lower maturity buckets.

"Till the last month we had about 20 per cent of the portfolio in over 10-year maturity papers. Now, such papers constitute only five per cent," says Surti.

Average maturity of the portfolio is down from 7.5 years to 5.5 years now. "We are shifting to medium-to-short maturity gilts to exploit the flattening yield curve," says Dhawal Dalal, fund manager fixed-income), DSP Merrill Lynch Investment Managers.

"Some shorter-term government papers are hovering around January levels making them good buys," says Binay Chandgothia, debt fund manager, IDBI Principal Mutual Fund.

"We have moved out of gilts in the 10-15 year maturity bucket in favour of 5-7 year maturity range," he adds.

Despite relatively high volatility, fund managers still hold a large portfolio of their debt fund investment in government securities. "We hold about 40 per cent in gilts because of liquidity considerations," says Surti.

As an investor what can you do in times of such volatility? Gilt funds are avoidable as they tend to remain more volatile than plain vanilla debt funds. Gilts are the most volatile debt securities, given their high liquidity.

So, when interest rates start to climb, a high exposure to government securities can actually take a huge bite from your bond fund's returns. Investors should study the risk-return profile of funds before making up their minds.

If you can't stomach the frequent bouts of nerve-jingling that accompanies gilt funds, then it's probably a good idea to switch a portion of your money to short-term debt funds.

In turbulent times, short-term funds tend to perform better than medium-term ones because short-term interest rates tend to be more stable and its returns are less likely to get bruised.

Also, invest in funds with a shorter duration because they tend to be less volatile.

Since fund portfolios with a longer duration have higher price sensitivity for a similar increase in interest rates, the price erosion is greater in these.

Another option could be to switch over to a floating-rate fund. Floating-rate instruments are insulated from interest rate risk, since here, interest rates are reset periodically with prevailing market rates.

So if interest rates creep higher, interest payments in case of a floating rate instrument will also edge higher automatically and vice-versa. (For more details refer to our cover story dated April 21, 2003).

But if you are looking for returns in excess of 10 per cent, plain debt funds could prove disappointing. The only option then is to choose funds with a dash of equity.

A balanced fund or a monthly income fund would be good option.