Ramesh Pathania/Mint
Ramesh Pathania/Mint

Choose short-term debt funds instead of FDs

Opt for ultra short-term bond funds if your time period is a month to six months.

The Reserve Bank of India (RBI) cut interest rates for the third time this calendar year when it cut the repo rate on Friday. Falling interest rates bode well for debt funds but should you still look at them despite three rate cuts already this year?

Lakshmi Iyer, head (fixed income and products), Kotak Mahindra Asset Management Co. Ltd, feels that there are chances of more rate cuts happening this year, unless oil prices go up sharply. “The general inflation trend in the economy seems to be on the downward slope, with WPI (Wholesale Price Index) hovering at around 5.96%. In the backdrop of moderating crude oil prices, and a possibly normal monsoon season, we can expect the inflation to be well within the tolerable threshold for some time. This may provide RBI with further room for rate cut in the time to come," she says.

But that’s just one reason to take a look at debt funds. In volatile equity markets, we may want to book profits and park our surplus cash somewhere. Some of us may keep this cash in our savings bank accounts but that earns just about 4% (though a handful of banks offer as high as 7%). Typically, if you are in the highest tax bracket (30%), we suggest you look at debt funds, especially if you have money to park for up to a year. And with interest rates expected to fall further this year, it’s a good time to lock your money in short-term instruments if that is what your horizon is.

Debt funds are complicated—to make the most of them, we need to understand how they work. Here’s what you should know about them.

Should you time the market?

Before we get to answer that question, keep in mind that interest rates and debt funds’ net asset values (NAV) move in opposite directions. Take a simple illustration. Say, if a debt scrip today carries an interest rate of 10%. If interest rates rise, new debt scrips that hit the market will offer interest rates in line with the prevailing rates in the markets. Assume new scrips offers interest rates of about 11%. Since the interest rates of these new scrips are higher than that of the old scrip, the price of the old scrip (the one that offers 10% interest rate) typically falls. Debt funds, which are invested in that scrip, will see their NAVs erode, as a result.

But falling interest rates may not always offer a chance to make the most of debt funds. In September 2008, when equity and debt markets across the world fell on the back of credit crisis, the 10-year government security (G-sec) rate also started to fall. Between 1 October 2008 and 31 January 2009, the 10-year G-sec rate fell from 8.454% to 6.255%. Looking at this fall, even if investors would have invested in debt funds in November or December 2008 or even in January 2009 and stayed invested for a year, they would have made with returns as low as 4%.

That is also because on 5 January, 2009, then finance minister Pranab Mukherjee announced an additional borrowing programme that spooked the debt markets. This begs the question: should you then time the market?

Sujoy Kumar Das, head (fixed income), Religare Asset Management Co. Ltd, suggests that one of the cues that investors should try and look at is the average yield of the 10-year benchmark scrip “over the past five to seven years". If the prevailing yield at the time of investment is higher than this average yield, investors can still invest.

“The chances of the prevailing yield moving towards the average yield are more than moving away. But if the prevailing yield is lower than average yield, then there are more chances of the yield moving up (towards the average yield); in the case of the latter, when yields go up, prices of debt securities—and therefore the NAVs of debt funds—go down," says Das.

By that logic, while the prevailing 10-year yield is about 7.75%, the five-year average is 7.87%. “We expect further rate cuts and easing of liquidity is also expected, going forward," says Navneet Munot, chief investment officer, SBI Funds Management Pvt Ltd.

Match your needs with duration

To get the most out of your debt funds, match your investment horizon with that of the debt fund. If you invest in a liquid fund, for instance, and then stay invested in it for long term like one or two or more years, your returns will be disappointing. Similarly, if you invest in a long-term bond fund, but withdraw within few months, you may end up losing money as they can be volatile.

Interest rates and bond prices move in opposite directions. A good measure to look at your fund’s sensitivity to interest rates is its modified duration. Most fund houses disclose this in their monthly factsheets. Expressed in years, this number will tell you how much your debt fund would get affected if interest rates (your bond fund’s yield) were to move up or down by 1%.

Assume your bond fund has invested in a 10-year bond with a face value of 100 and a coupon (interest rate) of 8%. Back of the envelope calculations show that the yield to maturity of this bond comes up to 8.16% and the fund’s modified duration comes to 6.77 years. In simple words, it means that if your fund’s yield rises by 1%, the bond price will fall by 6.77. Or if the fund’s yield falls by 1%, the bond price will rise by 6.77. The higher your fund’s modified duration, the riskier is your fund because its impact on change of interest rates will be high. Typically, long-term bond funds have a higher modified duration and vice-versa.

FDs or debt funds?

For those who wish to invest for more than a year, debt funds are more tax-efficient than bank fixed deposits (FDs). While interest income from FDs are charged as per the income-tax rates (10.30%, 20.60%, 30.90% including surcharge and cess), debt funds are charged at 10.30%.

In the short-term, debt funds are also charged at income-tax rates. Investors in the 30% tax bracket should opt for the dividend reinvestment plan. Although Budget 2013 increased the dividend distribution tax from 27.038%, up from 13.519% a year back, it is still lower than the marginal tax rate of highest tax bracket of 30.90%. In fact investors who earn more than 1 crore, the tax rate has now gone up to 33.90% (additional 10% surcharge on the base rate).

Keep an eye on FD rates though. These days, interest rates on bank FDs for a 60-90 day tenor yields 4-8.65%, as per data available on Apnapaisa.com, a loan portal. Deposits with tenors of 91-179 days pay an interest rate of 5.25% to 8.7%. Alternatively, ultra short-term bond funds have returned between 8% and 10% annualized on average, for a period of six months ending between November 2012 and date. “Since FD rates are not so great at the moment, investors can look at ultra short-term bond funds. That makes sense," says Anil Rego, a Bangalore-based financial planner.

Liquidity: While debt funds are liquid, bank FDs aren’t as liquid. For instance, if you invest in a two-year bank FD that yields an interest rate of 10% and you decide to withdraw after, say, six months, your bank will pay you an interest rate that was valid for a six-month FD, which could be, say, 6% at the time you invested. Many banks also add a 1% penalty charge for premature withdrawal.

Conservative vs moderate short-tenor funds

In times when interest rates are on a decline, typically short-term bond funds tend to invest in slightly longer-tenor securities and, therefore, their own average maturity or duration goes up. The average maturity of short-term funds was 1.86 years, up from 1.77 years in September 2013.

Check the fund’s allocation to corporate bonds, especially the longer-tenor bonds. While some funds invest about 20-30% in corporate bonds, few others invest as high as 70% in corporate bonds. Many ultra short-term funds, too, invest in longer tenor scrips.

As per data available by Value Research, a MF tracking firm, schemes such as Axis Short Term Fund, Kotak Bond– Short Term and SBI Short Horizon Debt Short Term have invested close to or more than 70% in long-term debt instruments such as corporate bonds and non-convertible debentures. Others such as Canara Robeco Short Term Fund and DSP BlackRock Income Opportunities have invested about 35% in such securities. “A high proportion of the portfolio in corporate bonds can fetch higher returns, but also increased the risk levels," says Akhil Mittal, senior fund manager (fixed income), Canara Robeco Asset Management Co. Ltd.

What should you do?

Opt for ultra short-term bond funds, if you wish to invest for a time period of a month to six months. Conservative investors can stay invested in them for even up to a year. For six months to a period of two years, go for short-term bond funds.