Over the last three years, fund professionals have been cautioning investors that interest rates are close to bottoming out and debt funds returns should settle at lower levels.

But every time they have said that, they have only been proved wrong. When investors hear the oft-repeated words, they tend to ignore them.

The fact, however, is that with rates having nearly halved over the past three years and with global interest rates poised to rise, domestic rates can't go far too down from here.

Debt: Medium term
(As on November 12, 2003)	Fund NAV (Rs)	Returns (%)
		3 months	1 year
Leaders
PNB Debt	19.59	3.38	14.23
SUN F&C FISF Long-term	12.03	3.05	13.9
HDFC Income Fund	15.56	2.89	12.78
Temple Income Builder	23.18	2.99	12.69
JM Income Fund-DQ	10.43	3.08	12.66
Principal Income	15.31	2.80	12.41
Sundaram Bond Saver	21.27	2.55	12.32
JM Income Fund-G	26.29	3.08	12.31
DSPML Bond Retail	22.62	2.76	12.22
Kotak Bond Wholesale	16.98	2.96	12.21
Laggards
Sundaram Select Debt	10.52	0.80	3.27
GIC Debt	10.70	0.82	3.82
Libra Bond	11.97	3.08	4.28
Principal Dep-EA/EB	15.45	1.00	4.95
BoB Income	11.03	1.82	5.85
LIC MF Children's Fund	12.11	1.49	8.13
UTI Bond	18.52	2.24	8.53
Tata Income	21.45	2.74	9.69
CanIncome	11.20	2.25	10.07
LIC Bond	17.79	2.26	10.16
Source: Value Research

Debt funds, thus, can't expect much by way of capital appreciation. Most debt funds managers expect to generate returns in the range of 5-7 per cent at best over the next one year.

While it may be unfair to compare debt-fund returns vi-a-vis equity-fund returns over the past year, it points to a huge gap in earning potential for investors.

While leading equity funds have bettered their index benchmarks by posting returns in excess of 90 per cent in some cases, their debt counterparts have been huffing and puffing.

The benchmark Crisil Bond Fund Index appreciated by a mere 10.74 per cent to 1189.07 (on November 11, 2003) over the past year which is comparable to the average annual returns offered by most mid-term debt funds.

Gilt funds performed best in the category, giving average annual returns of 15.64 per cent, followed closely by monthly-income plans which gave annual returns of 14.34 per cent on an average.

That's one reason mutual fund houses are now recommending medium-term debt investors to add a dash of equities to their portfolios.

The home front
For those who were hoping for a fillip in the Credit Policy were left rather disappointed. The RBI did not cut any of the key rates like the bank rate, repo rate and CRR.

"I think the RBI through its open-market operations before the Credit Policy had tempered market expectations considerably. Positions were adjusted before the Credit Policy itself. So to that extent, the expectations of a repo rate cut were very low. But having said that markets were expecting a cut in the bank rate if not anything else, because of the fact that the differential between the current repo rate and the bank rate at 6 per cent was very high," says Rajiv Anand, head of investments at Standard Chartered Asset Management Company.

However, fund managers found something to cheer about in the fact that the central bank has increased the GDP growth rate projection from 6 per cent to 6.5 -7 per cent while they reduced the inflation expectations to around 4 - 4.5 per cent.

Even in the murky scenario there may be a ray of hope. "The window for the rate cuts has been left open in that sense, especially if the liquidity in the markets continues to be strong. If one looks at interest rates in our country, one can safely say that in the medium-term interest rates will continue to remain soft and that the rates will not to go up," says Anand.

Binay Chandgothia, head of fixed income, Principal Asset Management Company, echoed similar sentiments.

"I think interest rates will be stable for some time to come, though it is likely to go down if inflation comes down to the levels projected by RBI. In that sense I don't think they have bottomed out yet. But any upward movement is likely to happen only in 2004," he says.

The global scene
If one looks at the global scenario, economies across the globe are looking up. Growth numbers in several economies including US and Asia are on the rise.

To that extent, the easing cycle we have seen in terms global interest rates seems to be over.

"If the growth that we have seen continues over the next three-six months we could see hikes in world interest rates. However, over short to medium term, we believe that interest rates will be on hold globally," notes Anand.

Countries like England and Australia have already seen a hike in interest rates, though more because of asset pricing issues. But these instances may be pointers to the future.

"Perhaps the next move in interest rates, especially in the US, will be upwards, but that will probably happen in the second half of 2004, if not later," hopes Anand.

Debt fund outlook
So should you stay put in debt funds? Not if you are hoping for returns achieved in the last two-three years, cautions Anand.

"I think the expectations about debt fund returns need to be tempered. It would be unwise to expect the same kind of returns as compared to the previous two-three years. What we have seen and what investors have benefited is from a structural change in interest rate environment in the last three years. So to that extent it is unlikely that one will see that kind of returns for some time to come," he says.

Large percentage of the returns generated by debt funds were out of the capital appreciation got out of bonds.

"Going forward the capital appreciation portion will not be very substantial. But even then debt fund returns will probably be better than bank fixed deposits," explains Anand.

Ramgopal Kundurthi, head of debt at IL&FS Mutual Fund, agrees. "The returns achieved during the past two years is definitely not sustainable. Those returns were achieved mainly through capital gains out of bonds because the interest rates fell sharply. Now that the rates are at a low, those returns look unlikely," he says.

Kundurthi further adds that the sentiments in the corporate bond market are also lacklustre with not much volumes happening. But the fact is that if you are a die-hard fixed-income investor, debt funds is the place to put your moolah in.

"Debt funds can give you returns superior to that of any other fixed-income instrument, like bank deposits," affirms Kundurthi.

Today, there are various types of schemes across various maturities capable of catering to every risk profile. And most of them offer better returns than bank deposits.

For instance, you can compare your savings account with the cash fund wherein the returns will be better than the former. Short-term funds can be pitted against the 90-day fixed deposits while the long-term funds can be compared against the one-year fixed deposits.

"Throw in the tax benefits, higher liquidity and transparency levels the funds provide you, it is clear that debt funds are a superior investment option in the fixed-income side," justifies Anand.

Chandgothia makes a case for investing in debt funds noting that there is a perennial need for debt fund investments for safer returns.

He also expects the inflows to be more in short-term funds rather than long-term funds, given the current market conditions. But Chandgothia is quick to downplay any expectations of a double-digit return out of debt funds.

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