Interesting investment opportunities in Debt Funds

Equity markets have been on the roll since last 3-4 years; giving mind boggling returns year after year. As such the debt funds have been reduced to as poor cousins of equity funds. People have almost forgotten about the debt funds.

On the contrary, even today more than 90-95% of the corpus of an average Indian investor is in the debt products, with barely 2-4% money in equity.

Don’t the above two statements appear contradictory?

Well, nor really. Most Indians are risk averse investors. Also, the past experience with equity markets has not been a happy one. Time and again scams have eroded their wealth and credibility in the equity markets.

Therefore, Indians have predominantly favoured ‘assured’ and ‘guaranteed’ returns from their investments. Hence the tendency to save in Bank FDs, NSCs, PPFs, Post Office schemes and such other products!

And because MFs are not allowed to offer assured/guaranteed returns - which means there is some uncertainty of returns - debt mutual funds have not enjoyed the kind of popularity they could have. (By the way, till few years back there were quite a few assured return products from MFs, which were quite popular with the investors. But these had some equity component and as equity markets crashed around the year 2000, these funds were in a problem to meet their commitments. Subsequently, SEBI had to disallow any assured-return MFs)

However, the MF industry has evolved and matured over the years. Secondly, in order to channel small savings into meaningful investments, the Govt. has offered attractive tax sops to the MF industry. Thirdly, the interest offered on assured-return products have progressively been aligned with the market rates.

All these developments have made debt MFs quite a safe and attractive investment option. Today MFs offer a wide bouquet of pure debt funds. Depending upon one’s investment horizon, tax status and liquidity needs, one can make his choice. Of course, no investment is without risk (many people have lost lakhs in bank deposits too). But as long as one makes an informed investment, he can minimize the risks and maximize the returns.

Before we look at how we can benefit from the various types of 100% debt funds, let us first understand the tax benefits and the various kinds of risks involved with debt debts. This will make the analysis more meaningful.

Tax Benefits

The interest income from the traditional investment options such as Bank FDs, NSCs, Post Office etc. (except PPF) are fully taxable. Therefore, if an investor is in the highest tax brackets, even the seemingly attractive interest rate of 9-10% actually means a net-return of just 6-7%.

Vis-à-vis this the income from MFs is taxed as under:

• Dividend Income (liquid funds): 28.325%
• Dividend Income (all other debt funds): 14.1625%
• Capital gains (short-term): same as on one’s normal income
• Capital gains (long term): 10% (or 20% with indexation).

Thus, except for liquid funds, one would have to pay a much lower tax in MFs. (if one has a short term horizon, he can always opt for dividend option and minimize the high STCG tax).

Risks of a Debt MF

Broadly, there can be two risks in a debt fund:

• Credit Risk: The money in debt funds is invested in interest-bearing instruments of banks, companies and Govt. such as bonds, FDs, GSecs etc. Therefore if a particular company or a bank defaults, then it will affect the returns. However, considering the fact that a particular scheme would invest in many companies/banks, a default by a few will not impact the returns much. Moreover, MFs invest mainly in top-rated instruments, where the risk of default is very low. So overall this is not a very big risk, unless of course there is a mass default or a MF invests in low-rated instruments.
• Interest Rate Risk: The interest rate and the bond price have an inverse relationship. If interest rates rise, bond prices will fall. Accordingly the NAV, which is calculated from the bond prices, will also fall. But if interest rates fall, bond prices and consequently the NAV will rise. And the longer is the maturity of a particular bond, the more it falls/rises.

Now let’s look at the various types of debt funds. Most of them are open-ended funds, except the Fixed Maturity Plans.

Normal Debt Funds

These generally invest in debt instruments of companies and banks, where the interest rate is usually fixed. Hence they are open to both credit risk and interest rate risk.

In this, there are both Short Term and Long Term debt funds. Short Term funds, as the name suggests, invest in shorter maturity instruments as compared to Long Term funds. Thus the impact of interest rate risk is lower for such funds. They are, therefore, more suited when interest rates are rising. Conversely, when interest rates are falling, Long Term debt funds are very good options.

Gilt Funds

In order to practically eliminate the credit risk, these fund invest only in Govt. securities. Now Govt. securities are 100% safe as regards interest and principal repayment is concerned. But they are also open to interest rate risks. Hence one should ideally avoid them when the rates are rising. But when interest rates are falling, they make a very good investment.

Herein too there are short-term and long-term gilt funds. And the same logic of interest rate risk applies here too.

By the way, with the rising interest rate scenario looking like coming to an end, the long term gilt funds (and normal debt funds too) recently gave almost 20% returns in 1-week (Jul 5-11) and short-term gilt/debt funds gave about 10% in 1-week. Therefore, if the interest rates start moving down, we can earn some very good returns over the next 6 months - 1 year from long-term gilt/debt funds.

Floating Rate Funds

These funds invest in instruments, which have an interest-reset clause (just like your floating rate home loans). This helps them to minimize the interest rates risks and offer fairly close to market returns.

They are therefore quite safe funds, as both credit risk and interest rate risk is low. Hence they are a good option, especially in rising interest rate scenario.

These funds have given an average return of about 7-8% over the last 6 months to 1 year, which on post-tax basis works out to about 6.15-7%. Similar have been the FD rates; but the post-tax returns work out to around 5.3-6.1%.
 
Fixed Maturity Plans

These are specially designed close-ended funds, where investment is made in instruments that will mature around the time the fund matures. Thus they minimize the interest rates risk and offer very good returns. Besides, with indexation benefits, the tax sometimes is virtually nil.

Today 1-2 year maturity funds can offer 8-9% post tax returns (even better than PPF), with practically very little risk.

Liquid Funds/ Cash Funds

These funds invest their money in very short-term debt instruments of banks and companies. Hence, they are ideal for people who want to park their money for say a few days or weeks.

As compared to earning just 3.5% p.a. from savings a/c (post-tax just 2.67% p.a.), one can today expect 5-6% returns from liquid funds (i.e. post-tax 3.9-4.7% p.a.)

Thus MFs offer a wide variety of debt funds and many of them are quite safe. In fact the only major risk is the interest rate risk, which too today is practically coming to an end, as interest rates seem to have peaked out. Besides they are quite tax-efficient as compared to the traditional debt products. A good portfolio can, therefore, enhance returns from our debt corpus too.

- Sanjay Matai