Role of Debt Mutual Funds

Most investors tend to think of debt or fixed income as a mere balancing number in their expansive asset allocation plans. While they spend a lot of energy thinking about equity investments, debt merely gets residual allocation, often without much thought. It is time to change this sub-optimal mindset. With the Indian markets offering healthy yields, debt investing through mutual funds in this scenario can make a strong contribution to one’s wealth creation goals and give a substantial boost to the portfolio.

Opportunities and Stability— Unlike what many think, debt is not an asset class that gives insipid returns. The return profile tends to be predictable and stable nature is the foundation of all good investment portfolios. Historical returns suggest that investors who have been smart with their debt allocations have made attractive returns in the past. Take the example of investors who have parked all their money in 10-year Government of India securities (G-Secs) in the last 15 years. They would have made a healthy 7.4 per cent CAGR at a time when the total return on equity benchmark Nifty 50 was 9.4 per cent.

Over the past decade and half, there have been multiple opportunities in 10-year government bonds or corporate bonds giving investors a chance to lock their investments for a yield as high as 8 per cent. Several debt categories in the same timeframe have delivered an average return of 7.15 per cent to 8.9 per cent CAGR. To be able to take advantage of the opportunities in the debt market, you need to develop quick thinking and develop a smart strategy. While equities will bring in the growth element to the portfolio, debt will provide stability. 

Exposure to debt ensures that the corpus for your financial goals remains liquid and relatively safe compared to equity funds. This is especially so when the goal is six months or one year away. This is an important factor if your wealth-creation process is aimed at achieving specific milestones such as the higher education of your children, their marriage, purchasing a second home, etc. It is also important to remember that investors’ risk appetite reduces with advancing age. So, higher allocation to debt becomes paramount. Also, increasing exposure to debt ensures that volatility in the portfolio too stands reduced.

Regular Income — It is common among investors to assume that they will rely on the dividend option for generating a stream of regular income. While dividends can be of benefit, their 1-2 per cent annual dividend yield is neither adequate nor assured unless massive amounts are involved. Here too one can consider using a Debt Fund to generate a funnel to structure regular income. For instance, systematic transfer plans and withdrawal plans can be used to switch your money from equity funds to debt funds and then generate income from debt funds in your bank account periodically. Such structures also benefit from the lower volatility of debt funds, which cut the overall risk of your portfolio and are very tax-efficient.

Tax Efficiency — Debt mutual funds are much more tax-efficient when compared to other fixed income substitutes. Interest earned on bank FDs and corporate FDs are fully taxable in investor’s hands at one’s applicable tax rate. These are taxed as income from other sources. But in the case of debt funds, the tax outgo can be lowered. For instance, long-term capital gains (LTCG) tax is at 20 per cent with indexation if units are held for more than 36 months. The indexation benefits applicable aids in optimising the effective tax rate. The income distribution cum capital withdrawal (IDCW) option which investors often consider opting for is taxable in the hands of investors. Here, the mutual fund house will implement TDS at 10 per cent for resident investors before payouts or re-investment. However, investors can claim tax credit of TDS deducted at the time of filing their annual return.

Debt Options to Consider — Often in traditional investment options like fixed deposits or corporate FDRs there is a penalty attached during times of an early withdrawal. When it comes to debt mutual funds, there is no such penalty. For the purpose of creating an emergency fund, or parking excess capital, an investor can consider options such as the liquid fund or ultra-short term fund. In the current scenario, when the G-Secs are at a historical peak of around 7.4-7.5 per cent, investors can consider medium and long-term debt funds, which may include medium-term bond funds, corporate bond funds, SDL funds, etc

And if the investor understands the ‘risk to reward’ aspect in the current scenario due to high interest rates and high G-Secs yields, he or she can choose a dynamic bond fund. Here, the fund manager based on his outlook has the freedom to change the modified duration of the debt funds to benefit from the interest rate volatility, thus creating an alpha over the other debt fund categories. If you are an investor with higher risk appetite, then you may opt for credit risk category fund. To conclude, in order to make your portfolio stronger, it is necessary that you give debt funds a serious thought so that your investments continue to post yields that your risk deserves.

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