Home >Money >Personal Finance >Inflation eats into returns of debt funds in a big way

India’s debt mutual funds at the very short end have been unable to beat inflation since the start of financial year 2020-21. In longer-dated categories such as corporate bond, banking and PSU debt, medium duration and gilt, funds have captured gains from interest rate cuts on bond prices but the trend may be one-off. It may be difficult for these funds to replicate the gains in the future unless there are sharp cuts in interest rates or inflation goes down in a big way.

In April 2020, a nationwide lockdown sent debt markets into a tizzy. A flurry of redemptions in debt funds investing in risky papers led to the shock freezing of six schemes of Franklin Templeton Mutual Fund on 23 April. RBI responded to this generalized panic through a series of liquidity-boosting measures and targeted repo operations, bringing down yields in the debt market. However, inflation remained above 6% in the next six months, squeezing debt fund returns.

To be sure, investors in other fixed-income products such as fixed deposits (FDs) have also been hit by the squeeze on rates.

Low returns

High inflation has forced some debt fund investors to accept negative returns in real terms. Real returns are calculated by comparing actual returns with inflation. They measure the ability of an investment to actually preserve and grow your purchasing power. For instance, the six-month average returns of liquid, ultra-short and money-market funds are 1.74%, 2.78%, 2.90%, according to data from Value Research. If we take half-yearly inflation to be 3% (inflation is usually taken at 6% as an annualized figure), these returns have not been able to beat inflation.

The returns of low-duration, short-duration, corporate bond and banking and PSU debt funds on average over the past six months are 5.18%, 5.84%, 6.18% and 6.19%, according to Value Research data, which means they have beaten inflation on a pre-tax basis. However, much of this is one-off due to rate cuts and may not be replicated going forward.

For instance, the yield to maturity (YTM) of short duration funds is 5.53% and banking and PSU debt funds is 5.36%. Even in case of gilt funds, the YTM is just 6.02%. YTM minus expense ratio provides a rough measure of an investor’s return in a debt fund, in the absence of defaults by bond issuers. Assuming an expense ratio of 0.5% on average for a direct (commission free) plan, this reduces potential returns to 5-5.5%. However, more rate cuts from RBI can provide additional gains to investors in these schemes but this will further depress yields in the bond market.

“Fixed income returns will be below inflation for the next couple of years. Rates have been artificially suppressed and I don’t see that changing," said Feroze Azeez, deputy CEO, Anand Rathi Pvt. Wealth.

What you should do

Traditionally, assets such as equity and gold are seen as solutions to high inflation.

After witnessing a sharp dip in March, the benchmark Nifty has delivered a return of about 26% over the past six months, but they may not be an option for debt investors. Financial advisers, typically, suggest equity for time horizons of seven years or longer and only for investors willing to take on higher risk. “There will be periods of low and high returns in debt funds. We are not asking people to shift into equity because of the higher risk there and also shifting attracts tax," said Lovaii Navlakhi, founder, International Money Matters Pvt Ltd, a Sebi-registered investment advisory firm. A redemption from a debt fund for a holding period greater than three years is taxed at 20% and given the benefit of indexation. A lower holding period is taxed at slab rates which could be as high as 30%.

Navlakhi was also skeptical of shifting to gold. “We don’t see gold as a hedge against inflation, but rather as an asset allocation product which can be 5-7% of the portfolio at the maximum," he said.

Investors should rebalance their portfolios to deal with inflation, but factor in the risks and tax implications when doing so.

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