Home / Opinion / Five reasons why one should own debt funds

A person recently turned 75 years old and received many wishes for a long and healthy life ahead. But he was a bit concerned that as expenses rose, his retirement income from assured returns products was declining. When he retired 15 years ago, he was confident that his interest income would suffice over his retirement. While he was used to interest rates of over 9% available to senior citizens, he was now earning less than 8% with the worry that rates may even drop further. It was a three-pronged attack—rising expenses, falling income and increasing longevity. With most Indians preferring assured return products, declining interest rates have become a real problem for people living on income generated from their savings. This has triggered a search for better options.

While mutual funds are gaining traction with retail investors, most new investors come via the systematic investment plan (SIP) route into equity funds whereas debt funds remain uncharted waters for them. Here are some numbers to illustrate this point: 80% of equity assets of mutual funds are held by individuals (retail 47% and HNIs 33%, as of April 2017). Only the remaining 20% assets are held by institutional investors. The picture is exactly the reverse in case of debt funds. Only 27% of debt fund assets are held by individuals (6% retail and 21% HNIs), whereas 73% of debt fund assets are held by institutional investors. I am sure this comes as a surprise to you as well that despite a tendency for the average Indian investor to be risk averse, the mutual fund industry appears to be an exception. Retail investors favour equity funds and hold assets under management (AUM) of Rs3,22,287 crore which is over four times the AUM held by individuals in debt funds (Rs78,697 crore). This anomaly is primarily due to the fact that mutual funds cannot offer assured returns and further compounded by the lack of awareness about benefits of investing in debt funds. 

Here are five reasons why one should consider owning debt mutual funds.

1. Time horizon: Unlike traditional assured return products, debt funds offer a wider variety. Regardless of the time horizon, there is a suitable debt fund. For short periods of less than 3 months, there are liquid funds. These are considered a good alternative to savings bank accounts as they come with high liquidity and relatively stable returns. Similarly, ultra-short term bond funds are suitable for a 3-month to 1-year period. Similarly, one can consider short-term bond funds for a 1-2 year horizon, medium-term funds for 2-3 years and long-term funds for 3-5 years. In each case, returns and risk are commensurately higher as one invests for the longer term.

2. Tax efficient: This is a key aspect of debt mutual funds. Unlike traditional assured return products, where interest income is taxed every year at income tax slab rates, with debt funds, only the change in net asset value (capital gains) is taxed. One pays short-term capital gains (STCG) tax at income tax slab rates only if units are held for less than 3 years. Thereafter, investors benefit from long-term capital gains (LTCG) tax at 20% and that too only on that component of the gain that exceeds inflation. So if you earn 9% per annum over 3 years from debt funds and the inflation rate is 5%, you pay tax only on the incremental returns of 4%. This is called ‘indexation’ and is calculated using the cost inflation index (CII). So, even if debt funds and bank deposits provide the same returns, after a 3-year period, one can get higher post-tax returns from debt funds. 

3. Regular cash flows: With declining interest rates and rising life expectancy, there is a fear that retirees may run out of their retirement corpus. Debt mutual funds can help to provide tax efficient regular cash flows via systematic withdrawal plans or SWPs. Say, you invest Rs25 lakh in a bank deposit paying 9% interest per annum. This will fetch you Rs18,750 every month. If you are in the highest tax bracket of 30%, you pay about Rs5,600 as tax on the interest received, and your net receipt becomes about Rs13,100. However, if you opt for SWP in a debt fund with the same monthly cash flow (Rs18,750), you end up paying only a fraction of the tax (as capital gains tax) thus generating much higher post-tax returns. 

4. Diversification: Debt funds are an important component of a well-diversified portfolio as their returns are typically more stable (less volatile) than equity funds. Thus, diversifying via debt funds reduces the overall portfolio risk.

5. Convenience: Assume you have a large sum of money to invest in equities but are unsure of when to invest. An SIP is a good way to build time in the market, and benefit from rupee cost averaging. But with interest rates on savings accounts at 4%, is this the best way to invest?

Here is where debt funds can bring a big benefit. Invest that same lump-sum in a debt fund instead of leaving it in your savings account. Then, start a systematic transfer plan (STP) to transfer smaller sums every month into equity funds from that debt fund. By doing this, you benefit from rupee cost averaging, while also earning better returns than a savings bank account on the portion remaining invested in debt funds. And if your money stays in the debt fund for more than 3 years, you benefit from lower taxation as well (due to indexation). As you receive additional lump-sums, you can simply top up your debt fund investment. You can even have more than one STP from the same debt fund. 

It is time investors allocate some portion of their savings to alternate options like debt mutual funds for the higher tax efficiency, variety and convenience. But do ensure that you understand the full risks and rewards of investing in debt funds. Ask your adviser about the different types of risk that a debt fund can take (interest rate risk, credit risk) and to invest in a fund that meets your time horizon and risk appetite.

Sanjay Sapre, president, Franklin Templeton Investments–India

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