Should You Invest in Long-Term Debt Funds?

Your plan to create long-term wealth might get hindered due to the volatile nature of the equity market. But, if you want to avoid the market instabilities of equities and are a risk-averse investor, consider parking your funds in long-term debtoriented mutual fund schemes. Vardan Pandhare analyses the opportunities present in long-term debt funds in this special report

If you have been an active investor in recent months, you have most likely come across numerous headlines on popular finance portals proclaiming that long-term Debt Funds can deliver double-digit returns going ahead. While these articles do catch your attention, they often fail to address the fundamental question about whether you should invest in long-term debt funds. Most of the information available regarding long-term debt funds only mentions that a drop in interest rates leads to a decline in bond yields, thereby increasing bond prices. [EasyDNNnews:PaidContentStart]

Consequently, long-term debt funds, which primarily invest in long-term maturity government bonds and corporate bonds, stand to benefit the most from such rate cuts. However, they rarely delve deeper into the topic and hence we took upon us to clear the smoke screen. According to SEBI classification, any debt fund with an average maturity exceeding seven years can be classified as a long-term debt fund. These funds are typically benchmarked against the 10-year G-Sec yield or Government of India bonds. Presently, the yield of the 10-year G-Sec or bond stands at 7.011 per cent.

A Long-Term Investment Plan

Debt mutual funds are suitable for individuals seeking financial stability and consistent investment returns. These funds achieve this objective by allocating investments across a diversified portfolio of debt securities such as fixed income instruments, treasury bills, government securities, corporate bonds, money market instruments and other debt securities with varying time horizons. By investing in these funds, investors can expect to receive a steady stream of fixed income.

The fixed rate of interest generated by the underlying assets remains consistent throughout the investment period. The debt fund manager carefully selects investments in line with their respective credit ratings. A higher credit rating indicates a higher likelihood of the debt security regularly paying interest and returning the principal upon maturity. Additionally, the fund manager adjusts the investment strategy in response to interest rate fluctuations.

Relationship between Bond Yield and Bond Price

To make informed decisions about investing in long-term debt funds, it is essential to grasp the concept and correlation between bond yield and bond price. While it has been commonly stated that a decrease in interest rates leads to a drop in bond yield, resulting in an increase in bond price, this relationship can be explained in two distinct ways that are not directly related. One is through a scientific justification and the other is through market sentiments, specifically the theory of supply and demand.

Although the calculations involved in this correlation can be intricate, let’s understand it using a simple example. Suppose a long-term debt fund investment entails purchasing Bond A with a maturity of 10 years, a face value of ₹1,000 and a coupon rate of 9 per cent. In this case, the bond price is ₹1,000, the average maturity is 10 years and the bond yield is 9 per cent. If there are no changes and the status quo is maintained, these three data points will remain constant. The fund house will receive ₹90 annually, which is 9 per cent of ₹1,000, as returns. The fund’s average return will remain fixed at 9 per cent. However, the real dynamics come into play when interest rates either increase or decrease.

Comparison between Bond Yield and RBI Repo Rate Movement

Let’s examine the potential consequences for long-term debt funds in the following two scenarios:

Scenario 1: Increase in Interest Rates

Assume that the Reserve Bank of India (RBI) has raised the repo rate, resulting in an increase in interest rates to 10 per cent. In this case, the fund house will still receive ₹90 as an annual return. However, due to the higher interest rate of 10 per cent, the bond price will decrease to ₹900. Although the absolute return remains fixed at ₹90, it now represents 10 per cent of the adjusted bond price, necessitating the reduction to ₹900. Consequently, the investor will experience a loss since the value of the bond has decreased to ₹900 from the initial purchase price of ₹1,000. To understand why the price of Bond A dropped by ₹100, let us consider the purchase of another bond, Bond B, after the interest rate increase. Bond B has a coupon rate of 10 per cent, a bond price of ₹1,000 and a maturity of 10 years. 

In this case, the fund house will receive ₹100 as an annual return while Bond A only yields ₹90. Both Bond A and Bond B have a face value or bond price of ₹1,000. However, over the 10-year period, Bond A will generate ₹100 less in returns compared to Bond B. Consequently, the price of Bond A is now ₹100 lower than the price of Bond B. In summary, when interest rates increase in long-term debt funds, the returns decrease, and depending on the fluctuations in the interest rate cycle, they can even turn negative. It’s important to note that while this example considers individual bonds for simplicity, the same correlation exists in government security (G-Sec) yields with different maturities.

Scenario 2: Decrease in Interest Rates

Currently, interest rates are on a downward trend. The RBI has reduced the repo rate twice in recent months. In this same example involving Bond A, let’s assume that the interest rates have now decreased to 8 per cent. Despite the rate change, the fund house will still receive ₹90 as an annual return on Bond A. However, the bond price will be adjusted to ensure that this ₹90 represents 8 per cent of the bond price. As a result, the bond price will increase from ₹1,000 to ₹1,125. This indicates that the bond will be traded at a premium of ₹125, equivalent to 12.5 per cent. 

The net asset value (NAV) of the long-term debt fund will also increase proportionally. Let’s consider the purchase of another bond, Bond C, after the interest rates have decreased. Bond C has the same bond price of ₹1,000 and a coupon rate of 8 per cent. Assuming a similar maturity of 10 years, the annual return from Bond C will be ₹80 compared to ₹90 for Bond A. In this case, there will be a higher demand for Bond A compared to Bond C, and market sentiments will drive the price of Bond A to around ₹1,125 until the bond yield is adjusted to 8 per cent at the current rate. Long-term debt funds that purchased Bond A at face value will benefit from both a higher yield and appreciation in bond price. In summary, in this scenario,long-term debt funds that bought the bond at ₹1,000 will gain the most, enjoying the advantages of a higher yield and an increase in bond price.

Furthermore, the government has proposed a comparable tax policy for insurance savings products. After March 31, 2023, maturity proceeds from these products will be subject to taxation for annual premiums surpassing ₹5,00,000. It is important to note that the proposed tax changes will not impact existing and new investments made prior to March 31. Tax experts suggest that this proposal could potentially strengthen the appeal of bank fixed deposits.

New Taxation Rules of Long-Term Debt Funds

The recent amendments introduced in the Union Budget 2023 have significant implications for a specified mutual fund as it will no longer receive indexation benefits when calculating long-term capital gains (LTCG). As a result, debt mutual funds will now be subject to taxation at the applicable slab rates. Furthermore, the removal of indexation benefits extends to LTCG on gold mutual funds, hybrid mutual funds, international equity mutual funds, and funds of funds. This change is likely to have adverse effects on mutual fund houses, as investors may opt to directly invest in debt securities to avoid additional fees or charges associated with asset under management (AUM). Additionally, the attractiveness of these mutual funds as an investment option may be affected as the tax burden on profits is expected to increase. 

Revised Taxation Rules for Debt Mutual Funds

The introduction of new taxation rules in India for debt mutual funds, effective from April 1, 2023, has garnered attention. According to the latest amendment, debt funds with 35 per cent or less investment in equity shares will now be considered short-term capital gains and taxed according to the Income Tax slab of individual investors. While this development has left mutual fund investors disappointed, its objective is to establish a consistent tax policy across all debt instruments and eliminate tax arbitrage Furthermore, the government has proposed a comparable tax policy for insurance savings products. After March 31, 2023, maturity proceeds from these products will be subject to taxation for annual premiums surpassing Rs 5,00,000. It is important to note that the proposed tax changes will not impact existing and new investments made prior to March 31. Tax experts suggest that this proposal could potentially strengthen the appeal of bank fixed deposits.

Impact of Proposed Changes on Investors

The proposed changes in taxation are expected to have various implications for investors, such as:

∎ Shift in Investment Preference — Long-term investments in debt-oriented funds will now have similar tax implications as bank fixed deposits. This may redirect investors toward the equity market and potentially impact the budding debt market.

∎ Impact on Senior Citizens — Senior citizens, who currently benefit from Section 80 TTB deduction on fixed deposit interest, will be particularly affected by the changes.

∎ Varied Impact on Different Investors — New and younger investors who typically opt for shorter-term investments in debt funds, as well as high net worth individuals (HNIs) or corporates whose investment strategies are not heavily influenced by tax implications, may not be significantly affected.

∎ Change in Investment Choices — Investors may consider shifting from long-term debt funds to alternative investment options such as equity funds, sovereign gold bonds, bank fixed deposits, or nonconvertible debentures in the debt category.

∎ Benefits for Banks — Banks are likely to benefit from these changes as they can attract customers with higher interest rates, leading to an increase in their borrowing and saving book sizes.

∎ Limited Choices and Increased Tax Revenues — Investors might be tempted to opt for riskier investments under equity mutual funds or safer havens like bank fixed deposits, resulting in fewer investment choices. Consequently, the government may gain additional tax revenues. Overall, the proposed changes may influence investor behaviour, potentially impacting investment preferences, market dynamics and tax revenues.

Bank FDs versus Long-Term Debt Mutual Funds

While bank fixed deposits (FDs) are considered a low-risk option, it doesn’t necessarily mean that investors should favour them over debt mutual funds. Debt mutual funds have the potential to generate higher returns, especially in stable or declining interest rate environments. If you are willing to take on slightly more risk in exchange for better returns, debt mutual funds may be a preferable choice. Investors in debt mutual funds have access to a wide range of options, including various liquidity levels, maturity periods and credit qualities. They can also choose between active and passive strategies.

Additionally, debt mutual funds have the flexibility to adjust their portfolios based on changing market conditions, within their investment mandate. This allows for the creation of personalised portfolios that align with individual financial needs. Ultimately, the decision between bank FDs and debt mutual funds depends on your risk appetite, return expectations and investment goals. It’s essential to assess your own preferences and consult with a financial advisor to make an informed decision that suits your specific circumstances. 

Points to Note

Consider this before investing in long-term debt funds:

1. Returns: Long-term duration funds have the potential to deliver impressive returns, particularly in a falling interest rate environment. In some cases, their returns can even outperform those of equity funds, reaching levels of 12-14 per cent. However, it is crucial to exercise caution as these funds may not fare well during periods of rising interest rates, and returns could reverse.

2. Volatility: Among debt funds, long-term duration funds exhibit higher volatility compared to short-term or medium duration funds. Any significant fluctuations in interest rates can lead to sudden changes in net asset values (NAVs).

3. Risk: Long-term duration funds carry substantial interest rate risk. Additionally, they entail credit risk, which can vary among different mutual fund schemes depending on the quality of the portfolio. Sudden or anticipated increases in interest rates can result in negative returns, even on certain days. It’s important to note that long duration funds are generally considered riskier options within the realm of debt funds.

4. Time Horizon: Investing in long-term duration funds necessitates a time horizon of at least 4-6 years. These funds tend to align with similar durations and are expected to deliver desired returns within this period. 

Considering these factors, investors should carefully evaluate their risk tolerance, investment goals and the prevailing interest rate environment before deciding to invest in long-term duration funds. Consulting with a financial advisor can provide valuable insights and guidance in making well-informed investment decisions.
 

Conclusion

In conclusion, investing in long-term debt funds in India offers the potential for attractive returns, particularly in a falling interest rate scenario. These funds have historically demonstrated the ability to outperform equity funds and provide stable income over an extended period. However, investors need to carefully consider the associated risks, including interest rate and credit risks, as well as the higher volatility compared to other debt fund categories. It is important to align the investment horizon with the duration of the fund to maximise potential returns. Seeking professional advice and conducting thorough research can help investors make informed decisions and effectively navigate the complexities of long-term debt fund investing in India.

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