Its Time For Debt Fund Investors To Act

Hemant Rustagi
Chief Executive Officer, Wiseinvest Advisors

Debt funds can play an important role in the portfolios of investors looking to earn higher returns than traditional options like fixed deposits and small savings schemes. There are variety of debt funds that allow investors to invest according to their varied time horizons. These are liquid, ultra-short term, short-term debt funds following different strategies like duration and accrual as well as dynamic funds. The major differentiator between different types of debt funds is maturity duration of their portfolios. 

Considering that an inverse relationship exists between interest rates and bond prices, funds with different maturity duration react differently to changes in interest rates. For example, in a falling interest rate scenario, funds that have longer maturity duration perform very well. However, in a rising interest rate scenario, these funds perform poorly. A case in point is performance of these funds over the last one year or so. 

In January 2017 when 10 year G-sec yield was 6.40, one year return for duration funds was in the range of 12-17 percent. Currently, when the yield is around 7.78 percent, i.e. a rise of 1.38 percent, one year return is in the range of 2-6 percent. During the same period, the impact of reversing rate cycle on short term income funds as well as funds following accrual strategy has been more subdued. That’s because accrual funds aim to take advantage of investment opportunities at the shorter end of the yield curve. 

While this explains how different debt funds in your portfolio may have behaved in the last one year, it’s time for you to have a close look at your portfolio and realign it, if required. At times, one can get swayed by short term performance of a particular category of funds due to favourable market conditions and invest aggressively in them. For example, many investors either began investing in duration funds or increased their exposure to these funds around a year ago expecting interest rates to remain low. However, the reversal in the rate cycle has left them disappointed as the returns have fallen substantially. No wonder, they are facing the dilemma of what to do with these funds. 

In fact, the recent hike in FD interest rates by some of the banks like SBI, PNB and ICICI Bank has made the situation even more tricky for them. If you are one of those investors facing the dilemma of how to tackle the current situation, you will do well to remember that debt funds remain a better bet than traditional options, both in terms of potential as well as tax efficiency of returns. Of course, the key would to realign the portfolio in line with emerging interest rate scenario. The short term income and accrual funds can be a good bet for a time horizon of 2-3 years. 

If you are willing to take some amount of risk to enhance your returns and have the time horizon to allow the impact of volatility in the market to get evened out, hybrid funds like equity savings and balanced advantageinvesting in a mix of equity, arbitrage and debt instruments can be a great option. These funds also score over debt funds in terms of tax efficiency of returns. 

To put tax efficiency of returns into a proper perspective, short-term capital gains in debt funds,i.e. gains realized on sale of units within three years are taxed at one’s nominal tax rate and long-term capital gains, i.e. gains realized after three years are taxed at 20 percent after claiming indexation. 

For equity savings and balanced advantage funds, short-term capital gains, i.e. any gains realized within 12 months are taxed at a flat rate of 15 per cent, and long-term capital gains, i.e. any gains realized after 12 months are taxed at 10 percent without any indexation benefit. On the dividend distribution front, debt funds are required to pay dividend distribution tax (DDT) @ 28.33 percent, whereas hybrid funds as defined above, are required to pay DDT of 10 percent. 

As is evident, a careful analysis of debt funds in your portfolio and realigning it by including hybrid funds can enhance your returns as well as allow you to stay ahead of inflation over the longer term.