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Invest in debt funds for best returns during market volatility

Invest in debt funds for best returns during market volatility

Debt funds, which invest in a range of debt and fixed-income securities of different maturities and credit quality, protect you from equity market volatility and offer decent returns. This could be the best time to bolster your portfolio with debt funds.

One golden rule of investing is that your portfolio should always include fixed-income products, no matter what your age is or how interest rates are moving.

If you have not followed this key commandment of investment and failed to cushion your equity portfolio with debt funds or other fixed-income instruments, it is as good a time as any to correct the mistake, thanks to the high interest rates being offered on debt products.

Debt funds, which invest in a range of debt and fixed-income securities of different maturities and credit quality, protect you from equity market volatility and offer decent returns. Before we go into the virtues of debt funds, let's look at why it is a good time to invest in debt.

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HIGH ON YIELD CURVE
Yields on bonds, both government and corporate, are high thanks to the Reserve Bank of India's (RBI's) 13 consecutive rate increases since March 2010.

The yield on 10-year government bonds maturing in 2021 with 7.8 per cent coupon rate, or interest rate, is close to 8.9 per cent, while the yield on three-month treasury bills (T-bills) is 8.7 per cent. One-year certificates of deposits (CDs), issued by commercial banks, are giving 9.5-9.7 per cent.

Among other options, banks are offering up to 9.5-10 per cent on fixed deposits, while non-convertible debentures (NCDs) are giving 12-12.5 per cent a year.

INTEREST RATES AND BOND PRICES
Interest rates and bond prices share an inverse relationship. When RBI increases rates, bond prices fall as bank deposit rates become more attractive than the interest rates on bonds. So, many investors sell bonds in the secondary market and go for the risk-free bank deposits, leading to a fall in bond prices.

Let us consider a bond issued by XYZ Corporation with a face value of Rs 100. Assume that it promises 6 per cent annual interest, called the coupon rate, till maturity.

In the secondary market, the bond is available for Rs 101. For someone who buys the bond from the secondary market, the current yield on the bond will be

= (Rs 6/Rs 101)X100 =5.94 per cent.

Tax on debt funds
Where Rs 6 is the coupon amount he will receive if he holds the bond till maturity and Rs 101 is the price at which the bond is trading in the secondary market.

Now, suppose interest rates are increased and the price of the bond in the market drops to Rs 99.

The current yield = (Rs6/Rs99)X100 = 6.06 per cent

So, while the coupon remains 6 per cent, the yield changes-5.94 per cent in the first case and 6.06 per cent in the second-according to the market price of the bond.

An investor who bought the bond at Rs 101 can either hold it till maturity and get 5.94 per cent annual interest or wait for the bond price to rise above Rs 101 to gain from capital appreciation.

The person who invested Rs 99 can either wait for the bond price to go up and gain from capital appreciation or hold till maturity and earn 6.06 per cent interest on his investment.

Fund managers who take investment decisions on your behalf deal with diverse debt securities with different maturity periods.

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WHY DEBT FUNDS?
Though the fixed income and debt space is attractive overall, debt funds have a few advantages over the more popular bank and corporate fixed deposits.

Choice: Mutual funds offer a range of debt funds with different tenures, investment objectives and portfolio composition. Depending on the duration and portfolio composition, debt funds are classified as liquid funds, ultra short-term funds, income funds, gilt funds, fixed maturity plans (FMPs) and hybrid funds.

A Steady Pile-Up
Liquid and ultra short-term funds are short-tenure funds that invest mainly in short-term debt such as T-bills, call money, commercial papers (CPs) and CDs; income funds are medium- to long-term funds that invest in a mix of money market securities and government and corporate bonds; and gilt funds invest in high-quality low-risk government bonds of medium- to long-term maturity.

Besides, there are FMPs, which are close-ended funds, and capital protection funds and floating rate funds.

More liquid: Most debt funds are open-ended and investors can exit or enter any day. The only exception in this case is FMPs. Hence, they offer better liquidity than bank and corporate fixed deposit schemes.

Diversified portfolio: Mutual funds provide you the option of having a diversified portfolio in terms of credit quality, asset class and maturity. A debt fund portfolio can include T-bills, CPs, CDs, call money and government and corporate bonds. It can also invest in NCDs as well as corporate and bank fixed deposits. A fund manager can rebalance the portfolio according to different interest rate scenarios and offer a decent return without taking too much risk.

Better post-tax returns: Debt funds are in general more tax-efficient, that is, lead to a lower tax liability, than bank and corporate fixed deposits. While interest earned on bank and corporate fixed deposits is taxed according to the investor's income tax slab, in case of debt funds long-term capital gains (redemption after a year) are taxed at 10 per cent without indexation and 20 per cent with indexation. Those who fall in higher tax brackets can save a lot of tax by investing in debt funds and thus get better after-tax returns.

Indexation is adjusting the purchase price of debt funds for inflation on the basis of a cost-inflation index that the government releases at the start of every year. This benefit is available only on capital gains booked after one year or more.

Short-term capital gains from debt funds are, however, taxed at the income tax rate.

MATURITY MATTERS
Though it is widely believed that interest rates in India have peaked and will either plateau or decline from here, some experts still expect the RBI to increase rates by another 25 basis points before finally reversing the rate-rise cycle. This has left investors confused whether to invest for the short-term (6 months-1 year) or a slightly longer duration (1-1.5 years or more).


"When interest rates are rising, it is better to remain invested in short-term products to minimise the risk and reinvest at higher levels."
Killol Pandya
Head of Fixed Income, Daiwa Asset Management

"Short-term income funds can offer best risk-adjusted returns for investors with an investment horizon of six months to one year."
Shriram Ramanathan
Portfolio Manager, Fixed Income, Fidelity Worldwide


Ideally, the decision should be based on the investment objective and when you require the money. "Investors must keep their requirements in mind and check the liquidity of the available instruments," says Harish Sabharwal, chief operating officer, Bajaj Capital.

The general wisdom is that one must invest for the short-term when interest rates are rising. "When interest rates are rising, it is wise to remain invested in short-term products to minimise the rate risk and reinvest at higher levels. When softening of interest rates is imminent or under way, it is better to invest for a longer duration to take advantage of capital gains," says Killol Pandya, head of fixed income, Daiwa Asset Management.

Shriram Ramanathan, portfolio manager, fixed income, Fidelity Worldwide Investment, however, says that short-term income funds with good credit quality have the potential to offer best risk-adjusted returns for those who have an investment horizon of six months to one year.

SHORT-TERM STRATEGY
Invest in short-term (six months to one year) income funds which have a portfolio of debt securities offering higher yields at maturity. If interest rates fall from these levels, you can benefit either from capital gains or get high yield at maturity.

"If an investor has idle cash in his current account or savings account, he should look at investing purely in liquid funds where there is relatively lower interest rate risk," says Lakshmi Iyer, head of fixed income and products, Kotak Mutual Fund.

Getting locked into one-year FMPs can fetch you a high 9-9.5 per cent return along with tax benefits. FMPs are close-ended mutual funds which invest largely in money market instruments such as T-bills, CPs and CDs.


"Those with an investment horizon of two-three years should invest in long-duration gilt funds to gain from capital gains once interest rates ease off."
Amar Ranu
Senior manager, Motilal Oswal Wealth


"For an investment horizon of 1-1.5 years, investors would be well off investing in short-term products, which are sitting at high yield to maturity. If the investor is very firm on tenure, he can lock into high-yield FMPs. At present, one-year CD is trading at 9.6-9.7 per cent. So, investors can expect a return of 9.2-9.4 per cent in the one-year category depending on the variable management and other fees of FMPs," says Amar Ranu, senior manager, Motilal Oswal Wealth Management.

However, if your investment horizon is short, say, less than six months, it is better to invest in bank fixed deposits, though one can park money in liquid and ultra short-term funds as well. Liquid and ultra-short term funds invest mostly in money market instruments such as T-bills, CDs and CPs.

At present, liquid funds are offering 8.12 per cent returns on an average, but that may change with the interest rate scenario in the country. Ultra short-term funds are offering 8.4 per cent, returns on an average, while short-term funds are giving 7.82 per cent, income funds 6.64 per cent and gilt funds around 4-5 per cent.

"Ultra short-term funds may generate returns when interest rates are stable or falling, but when interest rates are rising sharply they may generate negative returns. It also depends on when you enter the fund. One can look at a minimum duration of six months for such a fund," says Bekxy Kuriakose, associate vice-president and senior fund manager, fixed income, L&T Mutual Fund.


Funds for every season

Up to 3 months: FDs, liquid funds
6 months - 1 years: Ultra short term funds, FMPs
1 year - 2 years: FMPs; income funds
2 years - 3 years: Gilt funds; income funds


LONG-TERM STRATEGY
Those who want to invest for two-three years can opt for long-term income and gilt funds to gain from capital appreciation when interest rates start falling and bond prices start going up.

"Those with an investment horizon of two-three years should invest in long-duration gilt funds to gain from capital gains once interest rates ease off," says Ranu. Long maturity bonds are more prone to interest rate risk and hence have higher yields.

According to Shriram Ramanathan of Fidelity Worldwide Investment, investors should gradually increase allocation to open-ended bond products instead of locking all the money in close-ended FMPs as we are at the end of the rate increase cycle and there is a good possibility of gains from yields moving lower over the next year.

Debt funds do not offer guaranteed return like bank fixed deposits and post-office savings schemes but score over them on many counts such as liquidity and better tax-adjusted returns. Though debt funds cannot be an ideal replacement for assured return products such as the ones mentioned above, they can be used to build a good portfolio.

As Killol Pandya of Daiwa Mutual Fund says, "We see debt mutual funds as complementary to bank fixed deposits rather than a competitor."



TAKING NOTE: Moderate outlook for debt market

Sandesh Kirkire, CEO, Kotak Mutual Fund
The debt market performance continues to remain an intricate interplay of demand-supply equation and the unravelling of the inflation-interest rate conundrum.

For instance, the continued buoyancy in inflation remains the key concern for the domestic-economy watchers, and debt market participants alike. All the same, the landed oil price has palpably become dearer on account of around 10 per cent decline in the Rupee value vis-a-vis the dollar. At that, the unaddressed supply bottlenecks in the agri-sector, and high aggregate demand, continue to remain key contributory factors in fuelling inflation. The resultant hike in the interest rates has begun to curb the industrial investment and demand cycle.

Year-onyear comparison of September inflation
These factors are expected to weigh down on the economic growth outlook for FY12. As per the latest review, the FY12 GDP is expected to grow by 7.6 per cent for the current financial year. This is a downward re-evaluation from the May-July RBI projections of around 8 per cent.

Though, with inflation expected to start moderating by December 2011, RBI has indicated in the October credit policy that further rate hikes may not be on the cards. With inflation projected to mollify further to around 7 per cent levels by March 2012, we can expect the rates to decline in a short period from thereon.

In that context, we can expect the debt market to maintain a moderate outlook for now and wait out for the current interest rate-inflation complex to play out. The likely hike in the FII ceiling limit in Indian debt market may come as a sentiment booster.

SANDESH KIRKIRE
CEO, Kotak Mutual Fund

(Taking Note is a sponsored article)