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Fixed-income investments becoming attractive again

Returns from debt mutual funds have been muted for some time, but in the process, the accrual level has been moving up, which makes it relatively that much attractive.

May 30, 2022 / 08:25 AM IST
Representative image.

Representative image.

There is setback in the world of investments. Equity markets are volatile, bond interest rates are moving up, gold is not shining, crypto coins are vanishing.

In fixed-income investments, however, there is a one-to-one correspondence between interest rates going up in marked-to-market products and your accrual level moving up. To illustrate this, in debt mutual fund schemes, Net Asset Value (NAV) is computed every day, which is done at the valuation yield level of that day. Yield levels or interest rates have been moving up for some time and since yield and bond price moves inversely, the valuation prices are coming down.

Over a period of time, this drives up the accrual level of your portfolio. How does that happen? When the bond matures, it happens at face value. Since valuation was happening at a little lower level, it gives a kicker on maturity. Then, the proceeds are invested at a higher yield (i.e. interest) level. Moreover, when the fund gets fresh money, it is invested at a higher yield level than earlier. Net-net, returns from debt mutual funds have been muted for some time, but in the process, the accrual level has been moving up, which makes it relatively that much attractive.

How to gauge this level of attractiveness, which we are stating is better than earlier? It is the portfolio yield level, which is the Yield-To-Maturity (YTM) data available on the factsheet of any debt fund, which is the nearest available proxy. You can compare the yield level of debt funds today with that of say one year ago, and you can spot the difference.

Let us take an illustration of how much return you can expect, now onwards, based on portfolio YTM or net of fund-recurring-expenses YTM. The appropriate fund category to look at is Target Maturity Funds (TMFs). The reason is, in the usual open-ended funds, market movement of yield levels will influence your returns, either on the positive side (favourable to you) or on the negative side. TMFs also are open-ended funds, but here, provided you hold on till maturity, impact of market movement would be negligible. TMFs are available in various maturities, from 1 year to 10 years.

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Let us take a 5-year remaining maturity TMF, with portfolio yield of 7.34%. One year ago, the portfolio YTM (yield level) of this fund was 6.11%, which shows the uptick over last one year.

Portfolio credit quality of TMFs is top grade. Net of fund management expenses of 35 basis points (0.35%) in the regular plan, we take the net-of-expenses YTM as 7%. Assuming your holding period is at least 3 years, you are eligible for indexation for long-term capital gains (LTCG) tax. The final result depends on the extent of inflation and the benefit given by the tax authorities. Assuming inflation benefit at say 5.5% per year for the next three years, your net-of-tax return is 6.7% annualized.

This is decent, on a portfolio of good credit quality. Interim volatility will be there, as and when interest rates in the market move up. For this calculation to fructify or volatility to ease, you have to hold on till maturity or nearabout till maturity.

Similarly, on direct bonds, the yield levels have moved up as the bond market positioned itself for rate hikes, which the Reserve Bank of India has initiated now. For illustration purposes we will take tax-free PSU bonds rated AAA, which are available in various maturities. Let us take a tax-free PSU bond of maturity 6 years, available at a yield (i.e. annualized return) of say 5.1%. This level is approximately 1% higher than a year ago, which has happened due to interest rates moving up.

This being a tax-free bond, the return is net to you, without tax implication. There is a method for comparison of this level with other taxable bonds, where you would pay tax on the coupons (i.e. interest receipts) at your marginal slab rate. If you are in the highest tax bracket but earning less than Rs 50 lakh per year, you net tax rate is 31.2%. For comparison with other taxable bonds, the grossed-up equivalent is 5.1% / (1-31.2%) = 7.41%. That is, in a taxable bond, you need to get a yield of 7.41% to match 5.1% net of tax. If you are in the bracket of Rs 50 lakh to Rs.1 crore per year, your net tax rate is 34.32% and the grossed-up equivalent is 7.76%. To be noted, this is not to be confused with the TMF illustration mentioned earlier, as the taxation is different.

Conclusion

Now that yields / interest rates are rising, you may get a little better rates going forward. However, there is a cost of waiting as well, in a defensive product, as you would be earning lower for that period of time. You may stagger your investments, on the concept of a systematic investment plan.
Joydeep Sen is a corporate trainer (debt markets) and author
first published: May 30, 2022 08:25 am
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