In the past couple of years, investing in fixed-income options has become challenging considering the taxation changes.

Specifically, debt mutual funds faced much heat as indexation benefits were removed and all gains are being added to investors’ income and taxed at the applicable slab.

Therefore, any additional returns generated become important for investors.

In this regard, Tier 2 debt schemes of the National Pension System (NPS) have managed to steal a march over some of their debt mutual fund counterparts, making it an alternative avenue for debt fund investors.

NPS Tier 2 schemes are treated exactly like debt mutual funds with no taxation/deduction and indexation benefits.

These NPS Tier 2 schemes (G and C) have delivered anywhere from 60-190 basis points more than corporate bond, Gilt and banking and PSU debt fund categories across timeframes. The CAGR (compound annual growth rate) over one-, three- and five-year periods are taken for comparison. Since these are debt schemes/funds and they predominantly see lumpsum investments, point-to-point returns are considered. Category average returns are taken for comparison between similar NPS Tier 2 schemes and debt mutual fund categories.

Big outperformance

A comparison of the category average of NPS Tier 2 schemes from the GSec (government securities) segment with the category averages of Gilt, Gilt with constant maturity and long duration mutual funds shows decent outperformance.

NPS Tier 2 ‘G’ schemes category average was 12.5 per cent over a one-year period and 7.2 per cent and 7.5 per cent, respectively over three- and five-year timeframes.

In contrast, Gilt and Gilt funds with constant maturity category averages were a good 130 to 190 basis points lower over similar periods. Long duration funds managed to outperform over a one-year horizon, while as a category, they still lagged NPS Tier 2 ‘G’ schemes over three- and five-year periods by 80-90 basis points.

NPS Tier 2 ‘G’ schemes invest in government securities that mature anywhere from five to 40-50 years. Gilt and long duration funds have debt securities maturing in 10-31 years, while Gilt funds with constant maturity have close to 10-year horizon.

Thus, their performances are reasonably comparable. As interest rates peak and a declining cycle begins in a few quarters, longer duration bonds (and funds) can be expected to do well.

In the case of NPS Tier 2 ‘C’ schemes (corporate bonds), the outperformance over corporate bond and banking and PSU debt mutual fund category averages has been 60-120 basis points over different timeframes.

Typically, the maturity profile of the mutual fund categories mentioned above spans 3-7 years across schemes.

Though NPS Tier 2 ‘C’ schemes do invest in slightly longer maturities, they still offer scope for comparison.

Choosing NPS Tier 2

As mentioned earlier, given that fixed-income products face taxation and are not eligible for indexation, higher returns without taking any added risks would be welcome.

In that sense, with lower costs (0.09 per cent investment management charges), NPS Tier 2 schemes of ‘G’ and ‘C’ categories may be suitable for investors looking to lock in a part of their debt investments for the long term as a part of overall asset allocation.

However, NPS Tier 2 can be opened only by those who already hold a Tier 1 account (which has its own ‘G’ and ‘C’ schemes). Besides, once Tier 1 is closed, Tier 2 also get terminated automatically.

So, investors must consider parking only some portion of their long-term debt investments in Tier 2 schemes.

In any case, for shorter tenures, only mutual funds from money market, ultra short duration and liquid categories are available for investors.

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