Bond Funds - Invest for at least 3 Years

Retail investors, even those who have invested in debt mutual funds, haven't had it too bad in 2014. With average returns of almost 16 per cent for the one- year category, these schemes have been the top performer in the debt segment this year. And expectations of a benign interest rate environment in the coming year might help them to perform better in the coming year as well.

Fund managers have already started increasing the maturity of their papers.

But to get best results from your debt investments, remember to stay invested for at least three years.

The reason: Under new tax laws, you will be taxed at the rate of individual slab, if you withdraw before three years whereas after three years, you will be taxed at 20 per cent with indexation.

The inflation indexation benefit is substantial.

There are two kinds of benefits from bond funds - gains from interest income and capital appreciation.

The longer the holding period, the higher the contribution of interest income to the total returns.

Interest rates and bond prices are inversely proportional to each other. When interest rates fall, bond prices rise and when interest rates rise, bond prices fall.

In the current scenario, with interest rates expected to decline, duration funds should do well.

The biggest risk of investing in these schemes is high volatility.

Long duration bond funds are more volatile than short- term bonds. So, the longer one stays invested, the easier it is to ride out the volatility.

Due to this volatility, experts advise that while these instruments are good for the portfolio, limit the exposure to 10- 15 per cent. Retail investors should not allocate aggressively to these funds.

The biggest risk with investing in such funds is that the interest rate cycle might not play out as expected.

Analysts have been expecting the Reserve Bank of India (RBI) to cut rates for the past one year now, but the central bank has maintained a status quo.

If interest rates do not fall, or if the rate cut is not to the extent as it is being anticipated, one can expect volatility to increase in these funds.

In the past, fund managers have caught on the wrong foot by the apex bank.

Last July, several fund managers had increased the average maturity period of their long- duration funds, anticipating a fall in interest rates.

However, the strategy backfired, as RBI unexpectedly raised interest rates as part of its liquidity tightening measure and returns of some income and gilt medium- and- long- term debt funds declined three- four per cent on a single day.