Why past returns are not a good measure to identify the best debt fund

Representative image.

When most financial planners recommend debt funds these days to their clients, why are investors running scared? Data from the Association of Mutual Funds of India (AMFI; the mutual fund industry’s trade body) shows that in 11 out of 16 categories, debt funds saw net outflows (more money went out than came in) of Rs 10,316 crore in January 2023.

Perhaps it’s the way many investors pick financial instruments, especially mutual funds. According to Value Research, short-term debt funds returned just 4.37 percent over the past 1-year period. Government Securities or gilt funds gave a 2.85 percent return.

Let’s look at it the other way. If you had invested in debt funds (say, a short-term fund) at the beginning of 2021 or 2022, you would have earned returns of just 4.35 percent and 4.1 percent, respectively.

Instead, if you had invested in a bank FD, you could have easily earned at least 5 percent. More, if you had invested in a private sector bank’s or small finance bank’s FD.

The situation was far worse in the case of gilt funds, as they delivered 2.19 percent and 2.15 percent, on average, in CY2021 and CY2022, respectively.

No wonder investors are drawn to fixed deposits where returns are as high as 7 percent at the moment. “After three years of lacklustre performance by debt funds, investors are switching to fixed deposits — among other financial products — looking at current attractive interest rates. Recency bias has made them overlook the attractive yield to maturity of debt funds,” says Rajat Dhar, Director at Indian Investors Federation.

Not that bank FDs are bad, but comparing the returns of these two instruments is a mistake. Here’s why:

Did debt funds flop in the past?

There is a key difference between the returns from debt funds you see and a bank FD’s rate of interest.

A debt fund’s return is its past return. A bank FD’s return (its rate of interest), is what you’ll get in future. Comparing past returns with future returns is not a prudent approach.

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While a debt fund’s net asset value (NAV) moves in line with the interest rates and that has a cascading effect on existing investments, a bank keeps changing its interest rates on new FDs that it offers to prospective investors, as and when interest rates move. This shows that while a debt fund’s returns affect those who are already invested in them, a bank FD’s interest offering affects those who come in. Existing FD investors continue to earn the same rate of interest that they had contracted at the time of investment.

When interest rates go up, bond prices go down. Since the Covid-19 pandemic outbreak in 2020, central banks all around the world, including the Reserve Bank of India (RBI), started to cut interest rates to fight back an impending economic slowdown.

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Bond yields fell, too. Conversely, bond prices went up. This benefits debt funds; gilt funds recorded 3.7 percent and 4.06 percent returns in the quarter ended March 31 2020 and June 30, 2020, respectively.

Remember: a bond fund earns from two sources: the interest received by the fixed income securities it invests in. And capital gains as the prices of underlying fixed income securities get adjusted along with movement in the markets.

However, interest rates started to go up in 2021. Inflationary pressures were visible in most parts of the world, including India, and market participants anticipated that it was a matter of time before the RBI resorted to reducing the money supply and hiking interest rates.

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Bond yields started going up. Gilt funds gave 0.22 percent and 0.08 percent returns in the quarter ended December 31, 2021, and March 31, 2022, respectively. Although government securities come with a sovereign guarantee, they can also be volatile as their market prices move up and down as interest rates change. That also surprised many investors, who saw losses in their gilt funds, despite no defaults.

That’s why debt funds did badly in the past 1-3-year period.

A debt fund’s key is the YTM; not past returns

The way to look at a debt fund is to look at its Yield to Maturity (YTM).

Over the last year or so we have seen bond prices going down and bond yields going up. The same has been the case with the bonds held in the portfolio of debt funds. The yield to maturity (YTM) of the debt funds has also gone up. For example, the average YTM of all short-duration funds stood at 7.59 percent as on January 31, 2023, compared to 5.22 percent a year ago.

The YTM and expense ratio of a debt fund can together give you a ballpark idea of the future returns of the debt scheme. An investor today can expect returns equal to YTM minus expense ratio. So, for an average debt fund, if we assume 7.5 percent YTM and 50 basis points as the expense, then the indicative yield can be around 7 percent, which is fairly attractive if we compare prevailing interest rates on 3-year fixed deposits.

However, a word of caution, this indicative return is not sacrosanct. Due to changes in portfolio, changes in expense ratio, and redemption pressures, among other factors, future returns may change. But remember, YTM gives you an idea of what the debt fund’s future return is likely to be. The returns you read in a fund’s factsheet or its website are what the fund has already earned in the past; that has no bearing on its future performance.

Joydeep Sen, Corporate Trainer – Debt, asks investors to gather every bit of relevant information before making an investment call. “Investors tend to base their decisions on the things that are easily visible to them, such as the interest rates on offer on fixed deposits and past returns of debt funds. That makes most go for fixed deposits. But for those informed ones looking at the elevated yield to maturities of debt funds, the choice could be otherwise,” he says.

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Though no expert is expecting the downward interest rate cycle to start soon, most are of the opinion that the difficult times for debt funds are behind. Ajay Kumar Gupta, Chief Business Officer, Trust Mutual Fund, is one of them. “Despite increasing financial literacy in India, many investors still find it difficult to remain invested in the downcycle of an asset class. Those who remain invested for longer periods tend to do well. For debt funds, the down cycle could be behind us and we may see interest rates coming down after a prolonged pause,” he said.

Debt funds are also more tax-efficient than bank FDs.

A bank FD’s interest is taxed at income-tax slab rates. However, if you choose to keep your money in a debt fund, then you pay tax on capital gains only on the day of redemption.

Choose the schemes right

This can be a good time to invest in debt funds, wherein the duration of the debt fund matches your investment holding timeframe. Contrary to the mood of running away from debt funds, investors need to allocate money to them.

“It is difficult to predict which asset class will do well in a particular year. Investors, too, need to allocate their money across asset classes since they have varying needs such as growth, income and safety. Debt funds hence can be considered as an investment at a time when interest rate hikes are moreover behind us.”

While past returns are not the best yardstick to choose a debt fund, extending the same logic, this is not the best time to pour your money into liquid funds, just because they are doing better than the previous year. If interest rates go down over the year, then liquid fund returns will also go down.

Given the attractive yields now, it is the time to lock in your money using short-duration funds, long-duration funds and even target maturity funds, depending on your financial goals. Though debt funds are well positioned, going by the past, you would have realised that it may not be a smooth ride. Dhar advises debt fund investors to have a longer-term view. “There may be some more repo rate hikes in the offing and the rates may come down in CY2024,” he said.