In 2024, interest rates will fall. Here’s how to position debt mutual funds

Investing in debt funds is still a good idea, though the returns would be lower. But the current situation may offer a window to earn more.

Debt mutual funds are interesting products that allow one to invest across a spectrum of debt papers and tenures, credit quality and originators.

Such MF schemes are well-diversified within sub-categories such as short-term, banking and PSU debt, and corporate debt, based on duration, credit quality and originators.

Investors used to park money in debt funds because they were more tax efficient than other fixed income options. But the long-term capital gains treatment for debt funds was done away with from April 1, 2023.

Investing in debt products

So, are debt funds no longer a good choice? That’s not true because debt MF schemes offer good diversification, professional portfolio management, carry forward of losses for up to eight years, and excellent liquidity. As financial advisors, we still look at debt funds for investment in portfolios.

Investing in debt funds is still a good idea, though the returns would be lower. But the current situation may offer a window to earn more – this is covered later.

For tax-efficient participation in debt in a portfolio, one may have to look at other categories like hybrid funds, which have 35 percent Indian equity or more (with the balance portion usually debt).

There are balanced hybrid funds, which have about 50 percent in debt, and aggressive hybrid funds, which have about 30 percent in debt. The former still enjoys long-term capital gains treatment (20 percent taxation after indexation) and the latter would be treated as an equity fund and would enjoy 10 percent long term capital gains tax after 12 months of investment.

Also read | ULIPs back in focus after debt mutual funds taxation; But do they make sense?

Benefits of investing in debt funds now

Now, let us come back to true debt funds and examine the merits of investing in them at this point. The interest rate cycle has a lot of bearing on the returns of a debt fund. The returns of a debt fund are the sum of the interest from the underlying investments plus the capital gains (or losses).

The interest rate cycle seems to be somewhere near the top, with chances of a further rate increase by the Reserve Bank of India being low. In fact, the rate may start dropping in due course and may take 2-4 years to bottom out.

This makes investing in debt funds at this point a very favourable option because once the interest rate cycle starts moving down, the net asset value starts gaining, offering capital appreciation. This would boost returns from debt MF schemes. However, the appreciation potential varies based on the underlying investments.

Risks in debt funds

For all its virtues, a debt fund comes with some risks. The risks are twofold. Firstly, the rate cycle may not play out as expected if inflation stays beyond the RBI’s target range, there are economic growth concerns and extraneous factors emerge. Secondly, the credit quality of the paper may go down during the holding period.

The first risk is difficult to predict and actions will need to be taken based on what happens as we go along. That is the work of a fund manager.

The second one is easier – one can choose MF schemes that invest in high quality debt with a low chance of sliding on credit ratings, e.g. government securities, state development loans and AAA-rated public sector unit papers.

Also read | Will credit risk debt funds make a comeback?

Debt funds that would benefit

The amount of appreciation and capital gains is the highest with longer-duration securities, which are usually government gilts (also known as G-Secs). The other funds that benefit from sliding interest rates are those that have securities like state development loans, PSU bonds, bank papers, and corporate bonds, roughly in that descending order.

With this knowledge, we must choose the appropriate categories of debt funds, ideally matching our investment horizons, the expected interest rate trajectory, the expected spreads between G-Secs and AAA- or other lower-rated papers, and consequently, the risk we are willing to accept.

To lock in on capital appreciation, we need to exit when the interest rate bottoms out (or is nearly there). In cases when money is needed earlier, one can exit in between cycles, though the capital appreciation may be lower.

Government gilt funds with long-duration papers offer the best capital appreciation in a falling interest rate scenario. Hence, investing in funds with long-duration papers would offer the best appreciation potential.

There are funds that have state development loans entirely or state loans and AAA-rated PSU papers. These funds offer capital appreciation potential just behind those of G-Secs. The duration is generally lower than that of G-Secs.

Long-term income funds, also called income funds, may hold a combination of G-Secs, state development loans, bank papers, PSU papers and other corporate papers. The capital appreciation possibility here would be behind that of funds that predominantly have G-Secs, state developmental loans or PSU papers.

Medium duration or medium- to long-duration funds will also be similar to long-duration funds for the most part, except for the tenure of the underlying papers. Banking and PSU debt funds would be part of this category.

Lastly, there are corporate bond funds, which predominantly have corporate papers. The appreciation potential will be lower than in other categories, though the funds inherently offer higher interest than government paper-holding funds.

Just remember: in all these cases, one will have to sell near the bottom of the cycle if you are looking purely at capital appreciation.

Target maturity fund

We now have a target maturity fund – it is not a category but a type of fund that matures at a certain point, though it is open-ended throughout. This would be great if one wants to lock in the yield to maturity while investing.

In the normal case, one will not be able to enjoy any capital appreciation potential in such a fund because at maturity, the market price of the security will converge to the par value of the bond. If an investor wants to benefit from capital appreciation and wants to lock in, they will need to redeem the fund at an intermediate point.

Hence, debt funds by themselves offer great return possibilities at this point. This would be a wonderful window of opportunity for those who want to invest in debt/fixed income products and would like to enjoy returns from their fixed income investments that are better than the mean.