Falling interest rates on fixed deposits has pushed conservative investors to consider debt funds in search of high yields. But in most cases, they go by the past returns and commit their funds, which may lead result in lower returns than expected. Investors should instead factor in the macroeconomic situation and the actual portfolio yields to set their expectations right.
Decline in interest rates
Since the interest rates in the Indian economy have been on the decline, mutual funds will also deliver lower yields. For example, SBI’s one-year fixed deposit pays 5.1 per cent now compared to 6.8 per cent in February 2019. This is a 170 basis points fall.
If you invest in a debt fund, your return expectations should be proportionately lower than the returns given by them in the past. For example, banking & PSU bond funds delivered 10.95 per cent returns in the last one year, according to Value Research. If these schemes invest in bonds issued by banks and public sector undertaking (PSU) which are generally of high credit rating, then the returns should be following similar trends that are seen on bank fixed deposits. By investing in the same asset class without taking extra (credit or interest rate) risk, you cannot earn far more than a traditional option such as a fixed deposit. Since we are in a falling interest rate regime, lower your expectations.
Making sense of portfolio yield
Open-ended debt funds clearly mention the portfolio yield or the yield to maturity (YTM) in their factsheets. If you deduct the expense ratio of the bond fund, then you get the net yield – the return you can expect. “Though the net yield of a portfolio gives an indication of what to expect, real returns may differ as the market is dynamic, as yields or prices move up and down, the underlying portfolio may change with the changing view of the fund manager and inflows and outflows from schemes,” says Joydeep Sen, founder of wiseinvestor.in
The YTM for the short-term debt and banking & PSU debt fund categories stood at 6.8 per cent and 5.55 per cent, respectively, as on June 30, 2020. A high YTM is primarily an outcome of high credit risk, other thing remaining the same.
Capital gains
The total return earned by the investor includes the accrued interest on the bonds held in the portfolio and capital appreciation or loss arising out of changes in the prevailing interest rates. Interest rates and bond prices (and debt fund NAVs) move in opposite directions.
If you expect interest rates to continue their downward journey, you can expect more than the YTM. However if interest rates move north, the returns may get reduced, other things remaining the same. This is especially true if the scheme portfolio has debt instruments maturing over the long term.
So, for a debt fund with a net yield of around 6 per cent after accounting for possible capital appreciation, you should not expect more than 7 per cent, though the fund may have given more than 9 per cent in the last one year.
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