Debt funds, however, score over deposits, bonds and debentures on various factors, such as:
1. Better liquidity, i.e., debt funds can most often be liquidated without any exit load. However, for deposits, a penalty is applicable on early withdrawal
2. Debt funds are market linked and, therefore, when there is a rate/yield hike, the benefit is passed on to the investor immediately, unlike a fixed deposit
3. Debt funds are also an attractive option from a tax perspective for those who fall in the 20%-plus tax bracket. Debt funds enjoy indexation benefits in long-term investment. FDs are taxed at slab rate whereas debt mutual funds (MF) are taxed at 20% after indexation for a 3-year-plus investor.
As mentioned at the beginning, debt funds are one of the rewarding options today for the debt portion of the portfolio. The 5-year government paper, which was available at 6-6.1% in March 2022, is today available at 7.45%.
Inflation had seen a drop in November and December, to 5.7-5.8% levels, which was below the upper tolerance band of the RBI. However, the Consumer Price Index (CPI) numbers of January 2023 stood at 6.52% on account of a rise in food inflation. We are expecting inflation to revert to below-6% levels by April and as such, the RBI may continue to maintain the status quo on rates. Given the historical spread between the repo rate and the 5- and 10-year bond yields, there is a high possibility that these elevated yield levels may see some softening. In fact, we have already seen marginal softening of yields over the last 2-3 months.
A better approach for an investor would be to lock in to the high yields provided by central government bonds. Therefore, one can look at investing in the “target maturity fund” category of debt funds.
These funds follow a roll-down strategy, which means the fund manager invests in some instruments and holds them till maturity without trading in them. So investing in these funds takes away the return volatility if the investor stays invested in the fund till maturity.
Secondly, today out of a universe of 380-odd debt funds, there are 16 funds that follow a roll-down strategy and invest 100% in central government papers. These funds are available across maturities ranging from 2026 to 2036. Just in a few months, these funds have seen an asset under management (AUM) of Rs 12,000 crore.
So, an investor gets the benefit of locking into these elevated yields, with the highest credit quality possible and for a holding period that matches your investment horizon.
The icing on the cake is that these funds have tax efficiency. For example, let’s take an investor who is in the highest tax bracket investing in a 5-year maturity target maturity fund at a 7% entry yield. Assuming a 5% inflation for the next 5 years, the investor would end up with a post-tax return of around 6.5% in the debt fund. This is equivalent to investing in a bank deposit or any other coupon-bearing debt instrument offering 10% pre-tax return. As such, this is by far the most preferred choice of debt allocation in a client portfolio, keeping yield attractiveness, return stability and credit quality in mind.
However, a word of caution is that these funds are subject to mark-to-market norms as they have to publish their net asset values (NAVs) daily. So, depending on how the interest rate is fluctuating, there can be interim volatility in returns. As such, one should not get either excited or depressed when they see interim returns being higher or lower than their entry yield. As the fund reaches its maturity, these variations would converge and the return would be very close to the entry yield.
Lastly, one should not forget that debt is that portion of the portfolio which brings in stability and visibility to returns. From an overall portfolio level, one needs to beat inflation and generate 3-4% real returns. So, depending on your overall desired return goal and risk-taking ability, set your asset mix of equity and debt. Debt fund allocation is a kind of cushion to the overall portfolio and helps bring down risk so that one can smoothly navigate the turbulence brought by the equity market.