Prelude:
Bank fixed deposits and Government small savings schemes have been the traditional investment choice of average Indian households. As per Reserve Bank of India’s Quarterly Estimates of Household Financial Assets and Liabilities, Rs. 4,753 billion was invested in bank FDs in FY 2018 (the latest year for which data is available from RBI). On the other hand, despite its growing popularity, the share of mutual funds in household fixed income assets is still relatively quite small. As per AMFI data (February 2020), retail and HNI net investment in debt mutual funds in the last year (ending Feb 2020) was Rs. 260 billion.
Bank FD interest rates have generally been declining over the last 20 years, from 10 – 11% in 1999 to just around 6% in 2020.
Source: Advisorkhoj Research based on historical SBI interest rates (quarterly rates are averaged)
Similarly, Government (Post Office) small savings schemes’ interest rates are also on a declining trend over the last 20 years from 12% to around 7% in 2020.
Source: Advisorkhoj Research (quarterly rates are averaged)
The Government has already announced a cut in interest rates of small savings schemes. In the long term also, we may see a further decline in interest rates as inflation goes down in our economy.
Factors to consider before investing in Debt Mutual Funds
Debt funds offer a greater variety of products across the risk/return spectrum. It is, therefore, important for investors to select the right product according to their specific investment needs, risk appetite, and investment tenure. Before we discuss how to choose the right debt fund, we should understand the two main risk factors in debt funds:
Interest rate risk:
Prices of fixed income securities are inversely related to interest rate changes. If the interest rate goes up, the price decreases and vice versa. Different fixed income instruments have varying price sensitivities to interest rate changes. Price sensitivity to interest rate change is also known as duration. The longer the duration of an instrument higher is the sensitivity to interest rate changes.
Credit risk:
This refers to the risk of default i.e. failure to pay interest and/or the principal by the issuer of the fixed income instrument. Rating agencies assess the credit risk of fixed income instruments based on the financial strength of their issuer and assign a credit rating to instruments. If the credit rating of an instrument gets downgraded, the price of an instrument will fall. Likewise, if the credit rating gets upgraded, the price will rise.
Selecting funds based on risk appetite
Investors should understand that risk and return are directly related. Your return expectation should be equivalent to the risk profile of your investment. Investors should be aware of the linkage between investment tenure and risk capacity (especially interest rate risk). Shorter the investment tenure, lower the interest rate risk capacity, and vice versa.
Very short duration funds like overnight and liquid funds have very low-interest rate risk but their average returns are likely to be lower than debt funds with longer duration profiles. Similarly, short duration and medium duration funds have moderately low to moderate interest rate risk, but their average returns are usually higher than liquid funds over a sufficiently long tenure. Dynamic bond funds and Gilt funds have the potential of giving high returns but they can be quite volatile in the short term. So one should select funds according to your risk appetite.
Selecting funds based on investment tenure
As mentioned earlier investment tenure influences your risk capacity. You should try to match the duration profiles of your investment with your investment tenure.
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For very short investment tenures (few days/weeks/months), you should invest in overnight funds or liquid funds.
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For 1 – 3 year investment tenures, you can invest in short duration funds or similar funds whose duration profile is less than 3 years.
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For 3 years plus investment tenures, you can invest in dynamic bond funds and Gilt funds.
Debt funds can give higher returns
Debt funds invest in debt and money market instruments like commercial papers (CP’s), certificate of deposits (CD’s), Corporate Bond, T-Bills, G-Secs, etc. These instruments pay interest (coupon) at pre-defined intervals and the face value (principal) upon maturity.
The yields of many of these instruments are usually higher than bank FD interest rates of similar maturities. Yields of AAA-rated corporate bonds can be 150 – 200 bps higher than FD interest rates. In addition to higher yields, since these instruments are traded in the market, you can benefit from price appreciation.
The chart below shows the trailing returns of different debt fund categories over different tenures. Based on historical data, you can see that across different product categories (risk profiles) and investment tenures, debt funds have the potential to give better returns than bank FDs.
Source: Advisorkhoj Research, Data as of 1st April 2020, returns are average for each category, returns over 1 year periods are annualized.
Past performance may or may not sustain in the future. The returns shown above are returns of the category and do not in any way depict the performance of any individual scheme of any Fund.
Fixed income can outperform even in the long term
Extreme market conditions often challenge popularly held views. One view is that equity always outperforms in the long term. This is largely correct because historical data shows that, equity has been the best performing asset class in the long term. However, conventional thinking about what constitutes long term is now being challenged. The chart below shows the annualized average returns of some equity and fixed income categories over the last 3, 5, and 10 years. You can see that in certain market conditions, fixed-income funds can outperform equity even over fairly long tenures.
Source: Advisorkhoj Research, 31st March 2020
Past performance may or may not sustain in the future. The returns shown above are returns of the category and do not in any way depict the performance of any individual scheme of any Fund.
Debt Mutual Funds – Myth versus Reality
1. Myth: Debt mutual funds are as risky as equity
The risk of fixed income instruments is usually lesser than equity because the issuer of fixed income instruments is contractually obliged to pay a certain rate of interest and principal on the maturity of the instrument. The management of a company has no such obligations to pay the Dividend to the shareholders, i.e. only when there is profit and the Management decides to share the profits among their shareholders.
Dividends are distributed only after paying interest and taxes first. In debt instruments, there is a possibility of issuers not being able to meet their debt obligations. If a company goes into bankruptcy and its assets liquidated, bondholders are paid before shareholders.
Further, usually, most of the underlying instruments in longer duration debt funds are G-Secs, which have probably no credit risk because they have a sovereign guarantee. Purely from the point of view of underlying instruments, fixed-income funds are less risky than equity. Even if you take interest rate risk into account, longer duration fixed-income funds are less risky than equity. The chart below shows the annual returns of Nifty 50 versus Nifty 10-year G-Sec Index over the last 20 years.
Past performance may or may not sustain in the future.
2. Myth: Fixed deposit usually give higher returns
The reality is that on average and over a period of time, well-managed debt funds have been able to outperform fixed deposits. Fixed deposits are seen as risk-free investments. Investors should understand that risk-free investments usually give the lowest returns. The yields of many fixed income instruments are higher than bank FD interest rates of similar maturities. Yields of AAA-rated corporate bonds can be 150 – 200 bps higher than FD interest rates. The chart below shows bank FD returns versus top-performing (top quartile) fixed income fund returns across different categories and periods. You can see that the top-performing debt funds were able to outperform FDs on average (across different categories) over time.
Source: Advisorkhoj Research, * Average 1-year SBI FD interest rates, † Top quartile (top 25%) of fixed income funds in each category.
Past performance may or may not sustain in the future. The returns shown above are returns of the category and do not in any way depict the performance of any individual scheme of any Fund.
3. Myth: Invest in the debt funds aiming highest returns
Different types of debt funds have different risk characteristics. There are two main risk factors in debt funds – interest rate risk and credit risk. The longer the duration of a fund, the higher is its price sensitivity to interest rates, e.g. Gilt and dynamic bond funds are highly sensitive to interest rate changes while liquid and overnight funds have very little sensitivity to interest rate changes. Similarly, funds that invest predominantly in Government and highly rated papers have much less credit risk than funds that invest in lower-rated papers to capture higher yields.
Point to point returns in debt funds is driven largely by the interest rate and credit environment. For example, you should not select debt funds purely on the basis of recent returns. You should always invest according to risk appetite and investment needs and if need be consult your financial advisor before investing.
4. Myth: Liquid funds seek positive return
Historically, liquid funds have sought potential returns. These funds invest in money market instruments like CPs, CDs, and Treasury Bills, etc. CPs and CDs are unsecured money market instruments and only issuers with strong financial standing are able to get investors investing in such money market instruments. However, events over the past 30 months or so have shown that some liquid funds can give negative returns over certain periods. This has opened the eyes of many investors who were earlier blissfully unaware of credit risks in liquid funds. Investors should check the credit quality profile and investment track record of liquid funds before investing among other factors to be considered while investing.
5. Myth: Debt funds are meant for corporate and institutions, isn’t it?
While corporate and institutions account for a very large percentage of debt fund assets under management (AUM), these funds offer excellent investment solutions to retail investors for a variety of investment needs and risk appetites. You do not need huge sums of money to invest in debt funds – you can start with just Rs 5,000. You can also invest in debt funds through SIP. Apart from investing for your short-term, medium-term and long-term investment goals, debt funds are also useful for asset class diversification and reducing the risk profile of your investment portfolio.
Debt funds are tax-efficient
Bank FD interest is taxed as per the income tax rate of the investor. Capital gains in debt funds held for over three years are taxed at 20% after allowing for indexation benefits. Indexation benefits can reduce tax obligations substantially for investors in higher tax brackets. Incidence of taxation in fixed income funds arises only if you redeem (sell) your mutual fund units or if you receive dividends. Capital gains on your redemption proceeds and dividends are taxed differently.
Capital Gains Tax
There are two kinds of capital gains in fixed income funds:-
Short term capital gains:-
If units of fixed income funds are sold within 36 months from the date of purchase then capital gains arising out sale of units will be treated as short-term capital gains for tax purposes. Short term capital gains are added to your income and taxed according to your income tax slab rate.
Long term capital gains:-
If units of fixed income funds are sold after 36 months from the date of purchase then capital gains arising out of the sale of units will be treated as long-term capital gains for tax purposes. Long term capital gains are taxed at 20% after allowing for indexation benefits.
If you received the same maturity amount from a bank FD, then your tax outgo would have been Rs 8,280 if you were in the 30% tax bracket (plus surcharge & cess). The long term capital gains tax in the example above is nearly 60% less.
Dividend Tax
Prior to this financial year, mutual fund dividends were tax-free in the hands of the investors but the scheme (AMC) had to pay dividend distribution tax (DDT) at the rate of 29.12% for debt funds before paying dividends to investors. In this Union Budget, the Government has abolished DDT.
Dividends will now be added to your income and taxed as per your income tax slab. If you are in the 30% tax bracket, your post-tax dividend will now be lower (assuming the same dividend payout rate per unit), but if you are in the lower tax brackets your post-tax dividends will be higher. You should decide whether to invest in growth or dividend re-investment option depending on your individual tax situations.