Debt Ulips vs Debt Mutual Funds, which one is better?
Debt markets have been witnessing a strong rally lately after RBI‘s repeatedly move to slash rates. While investors are taking benefit of the rally by investing in bonds, debt mutual funds, there is one more category offered by ULIPs â€“ Debt oriented funds. Read this space to know if debt ULIPs worth a look over Debt mutual funds?
With the RBI cutting rates in response to positive news on the inflation front, debt markets have been witnessing a strong rally. Investors in long-term debt funds have been the biggest beneficiaries as NAVs of bond funds have appreciated significantly in response to the RBI’s rate cuts.
The yield on the benchmark 10-Yr government bond (gsec) fell to 7.11% levels by May-end from 7.99% levels at April-beginning. The rally tapered off once the rate cuts stopped and concerns escalated over the rupee and capital flight from Indian markets.
Investors keen on making the most out of the bond rally have been partial to long-term debt funds. As the name suggests, such funds invest primarily in long-term bonds. When there is a rally in bond markets, long-term bonds witness the biggest decline in yields. Consequently, bond prices witness a surge. This is due to the inverse relationship between bond yields and prices.
Another option available to debt investors is ULIPs.
ULIPs or unit-linked insurance plans are launched by life insurance companies to give individuals an opportunity to invest in equity and debt markets. The plans are market-linked and an NAV is declared which captures the investment value of the portfolio net of expenses. There is also an insurance component, but it plays a secondary role to the investment nature of the ULIP.
Individuals who want to evaluate the available debt fund options must consider the following factors while making an investment decision:
1. Expenses - Margins in debt investments are thin, when compared to equities. So selecting a low cost debt investment is important. If two debt investments have comparable returns, then the one with the lower cost is preferable. The amount you will save in cost will eventually reflect in returns.
Debt offerings of mutual funds are cost-effective relatively. Expense ratios of debt funds are capped at 2.25% by the regulator. It can go higher by 3.0% if the fund is being sold in Tier II and Tier III cities as required by the regulator.
Although ULIP expenses were higher earlier on, they are competitive under the revised expense structure proposed by IRDA – the insurance regulator. Now insurance companies can charge a maximum of 3% for a 10-year ULIP and 2.5% for a 15-year ULIP.
However, debt funds do not have an entry load and there is an exit load only on premature redemptions. In effect, there is no commission paid out to mutual fund agents by the investor. With ULIPs there is a commission paid out to the insurance agent, which can be quite high.
Investors looking at mutual funds have the option of buying a mutual fund scheme directly without the intervention of a advisor. There are direct plans for such investors. These plans have a different NAV from the regular plans. Direct plans can prove to be cheaper than regular plans by upwards of 50 basis points. The downside is they will have to make do without the assistance of a financial planner.
2. Insurance - Mutual funds are pure investment plans and do not have a life insurance element.
ULIPs have an insurance element. It is not as high as a pure insurance cover (term plan). While some may find the insurance cover of a ULIP as an add-on, it may prove quite unnecessary for individuals who prefer to keep their investment and insurance portfolios separate. Also the insurance element has a cost associated with it. So individuals who do not want the insurance will nonetheless have to pay for it while buying a ULIP.
3. Tax benefit - Debt funds do not offer any tax benefit. Short-term gains on debt funds are added to income. Long-term gains are taxed at lower of 10% without indexation benefit and 20% with indexation benefit.
ULIPs offer tax benefit at all three stages – at the time of entry, income/appreciation in NAV and at the time of exit/redemption. This is known as the E-E-E tax advantage. This is the most significant manner in which ULIPs score over mutual funds.
4. Lock-in - Long-term debt funds do not have a lock-in. There may be an exit load on premature withdrawals within say 12 months of investment.
ULIPs have a lock-in of 5 years over which period the individual must continue to pay his premiums.
While a lock-in does have its benefits in terms of enforcing investor discipline, it is more useful in an equity-linked investment. By its nature, debt is volatile and a beyond a point a lock-in serves no real benefit and may even prove counterproductive.
In our view, investor interests are best served by separating investment from insurance. An investment like a debt fund is more suitable vis-à-vis a debt ULIP. For insurance, individuals are better off seeking a pure insurance option - a term plan.
- Nirmal Rewaria
(The author is Senior VP & Business Head at Edelweiss Securities)