Invest in debt funds now and prepare yourself for the ride!

The normal wisdom is that debt investments would give consistent and sedate returns with low to very low risk. And Equity markets have the potential to offer high returns, but are prone to fluctuations and is meant for those who have a high risk appetite.

While this is still broadly true, debt markets currently seems poised attractively as the interest rate cycle is probably at the height of the cycle and is ready for a direction change. Debt funds have an inverse correlation with the interest rate cycle � the NAV goes up when the interest rates come down and it goes down when the interest rates move up. So, when the possibility of an interest rate slide seems imminent, it would be a good idea to invest in debt funds.

Now, what are these debt funds and what should be the tenure of the investments? There are ultra short-term funds which are typically used for parking short-term funds. Also, these are used for keeping the money required for liquidity needs, as the tax treatment as compared to a short-term FD in a bank, is favourable. In short-term FDs, the interest income earned is added to one�s income and taxed at the applicable slab rates. If a person falls under the highest tax bracket, they would have to pay 30.9% as tax, on income earned. This means that if they have invested Rs.100 and have earned Rs.10, they would pay a tax of Rs.3.1 and retain only Rs.6.9. However, a person investing in a debt fund can opt for a dividend distribution option, where the dividend distribution tax is about 13.5%. Hence, on Rs.10 earned in a debt fund, the net income would be higher at Rs.8.65. The post-tax returns are higher in a debt fund by Rs.1.75 ( Rs.8.65- 6.9 ). This is 25% more post-tax income as compared to what one can earn from a FD. This gives a halo to debt funds.

Also, the rates for 90-180 day FDs are in the region of 6.5 � 7.5% pa, whereas the ultra short-term funds are currently offering over 9% returns now. This means that for short tenure investments, investing in these debt funds is doubly attractive � better returns to start with and better tax treatment. So assuming a median 7% return on FDs, the post-tax returns (for those in the highest tax slab ) is 4.83%. In case of ultra short term funds in the debt option, it is 7.79%. That is almost a 3% difference. The earnings from Ultra short-term funds are a whopping 62% more than the short-term FDs. So there is a clear case for investing here for the short-term ( upto 1 year ).

In case of somewhat longer tenure of over a year, debt fund returns are subject to long-term capital gains of 20% with indexation or 10% without indexation. Currently, the yield for shorter tenure papers are higher as compared to longer tenure papers. The yields for one year Certificate of Deposit (CD) are 9.9%+, which is what is making the yields of the short term debt funds, very attractive. Commercial Paper (CP), Structured Obligations, PTC, Non Convertible Deposits (NCDs), Bonds etc., would also be there in some portfolios and could boost yields, but may come with a higher risk. The average returns of 2-3 year papers is in the 9.4 � 9.6% region. However, it offers prospects of good post-tax returns due to the indexation benefit and NAV appreciation due to falling interest rates. There is a prospect of earning double digit returns, which is attractive.

There are different types of funds which one could consider investing in. There are actively managed funds, where the fund manager would take a call on durations and papers. Based on the fund manager�s skill, the returns can be expected to be good.  There are many funds of this nature which an investor can look at. A couple of examples would be Birla Dynamic Bond Fund and Templeton India Income Opportunities Fund.

There are other medium to long-term funds which are variously called as Income funds, Bond Funds, Gilt funds etc., depending on their composition. All the components of the portfolio are subject to fluctuations depending on the interest rate movements - the longer the tenure, the higher the fluctuation due to interest rate reduction.

However, since how rapidly the interest rates may be brought down is not known, it makes sense to be at the shorter end with average maturities of up to 3 years. One could look at longer maturities for a lower portion of their portfolio � typically about a third of the portfolio. Invest now and prepare yourself for the ride!

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-Suresh Sadagopan

The author is a Principal Financial Planner at Ladder7 Financial Advisories. You can reach him at ladder7@gmail.com