How to befriend unfixed returns given by fixed income

Gajandra KothariEtica Wealth Management

The moment fixed income comes into our mind, we tend to think of fixed deposits or small savings schemes which offers us the fixed return. But fixed income is not really fixed in the true sense. For example – the interest on PPF is reset every year. One cannot plan for a goal for next 15 years based on the return of PPF as the interest rates will keep changing every year. Going Forward, the returns from the traditional fixed income instruments will increasingly become market linked as Indian economy keeps integrating with the world economy. So, how should one deal with this kind of situation. The only answer is to accept this reality and plan the investments keeping the interest rate scenario in the country. Luckily, today we have plenty of options available to invest beyond the traditional fixed income investments depending on the interest rate scenario in the country and this is where fixed income mutual funds comes very handy.

Before we delve into what instrument one can invest in the mutual fund fixed income space, it is important to understand the relationship between interest rates and bond prices.

Relationship between Bonds Funds and Interest Rate: Interest rates and bond prices share an inverse relationship. Bond prices move in the opposite direction of interest rates. When rates fall (as they have been doing for last 1 year), bond prices rise. When rates rise, bond prices fall.

To determine how dramatic a fund's ups and downs might be in a changing-rate environment, check out its duration. Duration measures a fund's sensitivity to interest rates. The higher a bond's duration, the more it responds to changes in interest rates. If a bond fund has duration of five years, you can expect it to gain roughly 5% if interest rates fall by one percentage point, and to lose 5% if interest rates rise by one percentage point.

For example, If the net coupon of bond fund is 7% and duration is 5 Years and if interest rate falls by 1%, these funds would deliver 7%+ (1%*5 Years) = 12% return.

If you are an investor who wants to enjoy the fixed nature of the fixed income investment and who becomes nervous with the sharp interest rates movement then you can consider investing in the following options.

Liquid/Ultra Short Term Bond Fund: Liquid Fund/Ultra Short Term Fund are money market funds which invest in Treasury bill, Certificate of Deposit, Commercial Paper, call money market normally not exceeding maturity of 60 days to 90 days. These are very safe investments and are idle for parking money for 1 day to 60 days or for any emergency requirement. This fund on an average gives much higher return than a savings bank account / current account with the advantage of low risk and high liquidity.

Short Term Debt Fund: Short term debt fund are income funds which are one notch higher in terms of their risk/return profile compared to Ultra Short Term funds. They invest in debt papers which are mix of G-sec and corporate and the weighted average maturity of the portfolio is upto 3 years. These are also relatively safe investments and are ideal for parking money for a horizon of 3 months to 1 year.

Fixed Maturity Plans: FMPs as the name suggest are mutual funds which are for fixed tenure and invest in fixed income instrument. These are great alternative to fixed deposits and are truly fixed in nature as far as the interest rates are concerned. The tenure of FMP could be 30, 90, 180, 365 days or more and they invest only in such securities that mature on or before the date of the maturity of the scheme. Unlike open ended funds, these funds cannot be withdrawn before maturity. These funds are close ended in nature and for liquidity purpose they are listed on stock exchange. . The funds are most suitable for investors in higher tax brackets as it aims to offer superior post tax returns compared to FDs over a three year horizon. One can also go for indexation benefit which is not available in FD’s and hence is suitable for investors in higher tax brackets.

Credit Opportunity Fund: Credit Opportunity/Income opportunity fund primarily invest in securitised debt, NBFC and corporate papers upto 3 to 5 years maturity. These scheme aims to generate higher yield (accrual) to the portfolio by investing in slightly lower credit quality paper. These fund carry lower interest rates risk but higher carry higher credit risk. These funds normally carry exit load for longer tenure and ideal investment time frame is 18 months to 2 years for most of the funds.

All the above mentioned investment options offer more or less stable returns and are less risky in the rising interest rate regime. However, If you want to benefit from the falling interest rate scenario then the following funds can offer additional returns to your debt portfolio

Dynamic Bond Fund: Dynamic bond fund as the name suggest are actively managed by fund manager, where he/she can increase and decrease the duration of the fund based on his view on interest rates. These funds are all season funds as fund manager dynamically manages the duration based on changing macro environment. This fund carry relatively higher fund manager risk and have higher turnover ratio.

Long Term Gilt Fund: These fund invest only in papers issued by either Central or State government of India. These funds do not carry any credit risk but relatively higher interest rate risk as these funds can invest in papers upto 30 years maturity. Most of these funds do not have exit load and ideal for investors and traders in debt market to execute their tactical calls and reap huge benefits when interest rate falls as has been the case for the last 1 year.

Long Term Income Fund: Long term debt fund invests in G-sec and corporate papers. The weighted average maturity of these funds is in range of 5 to 8 years. These funds are suitable investment option in falling interest rate scenario as in addition to accrual (coupon) they generate capital gain when interest rates fall. These are ideal investments for a 1-3 year horizon in the falling interest rate scenario.

Taxation of Indian Debt Mutual Fund:

Dividend: Debt mutual funds are liable to pay dividend distribution tax before paying dividend to individual/HUF or any other person. Currently the dividend distribution tax is 28.33% on dividend declared by all debt funds and the dividend is tax free in the hands of investor. This is not an ideal option to chose as tax is deducted at source.

Capital Gain: Short Term Capital Gain: If investor holding period i.e. buys and sells the debt fund in less than 3 years, it is considered as Short Term. Short Term Capital gain is taxed as per normal rates, i.e. as per investor tax slab. For example, If investor falls under 30% tax bracket, he would be taxed at 30% and so on.

Long term Capital Gain: If investor holding period i.e. buys and sells the debt fund after 3 years, it is considered as Long Term. Long Term Capital gain is taxed at 20% with indexation benefit.

If investor has a time horizon of more than 3 years and falls under higher tax brackets, he should opt for growth option instead of dividend option as these leads to better tax efficient return.

As seen above, debt mutual fund offers indexation benefit which is not available in traditional fixed income instrument. Investors can also enjoy double taxation benefit by planning smartly. If an investor invests in March and redeem the money in April next year, effectively he has invested only for 1 year and 1 month, but since he as crossed two financial years, he get double indexation benefit.

While investing in debt funds, investor should have broad view on two things, how is interest rate going to play out in future and how the credit scenario in the country is. Based on the investor expectation of Interest rate and Credit Spread, he can select the debt mutual fund as mentioned below

Scenario 1: Interest Rate Expected to go down (Bullish) and Credit Spread expected to narrow down (Bullish)

• Investor should overweight Duration and Overweight Credit. • Hence investor can invest in Long term income fund.

Scenario 2: Interest Rate Expected to go down (Bullish) while Credit Spread expected to narrow down (Bearish)

• Investor should overweight duration but underweight credit. • Hence investor can invest in Long term Gilt Fund

Scenario 3: Interest Rate Expected to go up (Bearish) while Credit Spread expected to narrow down (Bullish)

• Investor should underweight duration but overweight Credit. • Hence investor can invest in low duration accrual fund or Ultra Short term fund

Scenario 4: Interest Rate Expected to Go up (Bullish) while Credit Spread expected to narrow down (Bullish)

• Investor should underweight duration as well as underweight Credit. • Hence investor can invest in cash or liquid fund.

Mutual funds offer variety of debt funds and based on risk appetite and time horizon investor can choose various schemes. In a falling interest rate scenario, it is advisable to invest in long term bond funds as these fund in addition to generate accrual would offer capital gains once yields falls. And in rising interest rate scenario, investor should be in lower maturity funds.