Investors in debt funds generally fund it difficult to understand, why their returns over one year are less than the returns which they can earn in fixed deposits over a similar period. Investors need to understand the interest rate risk which is embedded even in the perceived safety of instruments like the Government securities. The government securities generally do not carry any credit risk but they come with interest rate risk and liquidity risk.
The returns in Government securities consists of three components
1. The Yield of the instrument
2. The re investment rate of the coupon available half yearly basis
3. The terminal rate when the investor exits
The most important part of the returns in Government securities consists of the Yield to maturity of the instruments subsequent and lower importance may be the terminal rate of investors exit. The re-investment rate and the terminal value rate of exit form a small component of the returns which are generated by investing in a Government security.
Generally higher the accrual of the bond, higher is the protection which the investor may get from investing in Government securities bond as the accrual is able to set off any losses which the investor incurs during his holding period. Conversely, if the accrual component is lower and interest rates move up, the investor returns may reduce dramatically
I believe a prudent investor should always look at the prevailing yield of the bond before making his investment as it may give him protection against losses due to higher accrual. If interest rate falls, the prudent investor would benefit due to the capital appreciation which he can get from the bond even though the re investment rates of his coupons will be lower.
If the investors feel the Yield on the instrument is attractive, he should buy a longer dated papers as he may be able to lock into the rates for longer period of time. The investors may be benefited vie capital appreciation on the bond even though the re investment rates would be lower. Conversely, the investor who wants to invest when yields are low and expect yields will go up over a period of time, can buy shorter dated instruments as the investors may suffer capital loss when yields move up but when the paper matures he can re invest the proceeds at higher yields. He can continue to do this till he feels interest rates have peaked and subsequently lock into higher yields for longer maturity. However, the investors who do not have the time and efforts to track this on a daily basis can invest through gilt fund schemes of mutual funds . The fund manager of gilt funds can proactively manage the maturity of the schemes based on the interest rate outlook. The investor should select funds which have low expense ratio as the returns on the debt funds depends on the yield of the portfolio and higher expenses can reduce the returns which the investors may get after deduction of management fees.
Disclaimer: Mutual fund investments are subject to market risks read all scheme related documents carefully.