Fundamentally. Don’t write off debt funds

Confusion has reigned supreme ever since the Finance Minister proposed tax changes on non-equity mutual funds in the recent Budget.

The first question was whether the long-term capital gains (if you hold these funds for more than three years) would be taxed at a ‘flat’ 20 per cent or at 20 per cent with indexation benefits. The Budget documents make it clear it is the latter.

Then, there was a furore about the retrospective effect. Would investors who bought debt funds in the last two years now have to pay higher tax if they sold their investments?

The new finance Bill clarifies that investors who sold their debt fund investments between April 1 and July 10 this year will not suffer the higher rate of short-term or long-term capital gains tax announced in the Budget. But investors who didn’t sell them so far will still have to fork out capital gains tax.

So now that the special tax advantage that debt funds enjoyed is gone, should you still invest in them? The answer is still a resounding ‘Yes’ for open-ended debt funds. Here’s why.

Before selecting any new investment option for your portfolio, it is necessary to put it through four tests — returns, risks, liquidity and tax-efficiency. Though the Budget has curbed the tax-efficiency of debt funds, they still score high on both returns and liquidity.

Debt funds will now have to compete with alternative avenues, such as bank deposits and small savings, purely on their ability to deliver superior pre-tax returns.

While passive close-ended products such as FMPs will find this quite a tall order, actively managed debt funds may still manage it, by making the most of movements in interest rates.

If they perceive interest rates declining, they can load up on longer-term bonds to gain from bond price rallies.

If they expect an improving macro picture, they can buy lower-rated bonds to benefit from credit upgrades. Such funds can also mix and match a vast array of debt securities in their portfolio to earn better returns — corporate bonds, certificates of deposits, State Government bonds and good old government securities.

Open-ended debt funds have delivered much higher returns than comparable bank products in the last three years using this strategy.

Liquid and short-term bond funds, which are usually parking ground for short-term money, have managed a three-year return of 9 per cent on an annualised basis, compared to the 6 per cent offered by the best savings accounts.

Even if returns from these funds moderate over the next year or so, returns of 7 per cent would be well within reach.

Similarly, income and gilt funds with a three- to five-year horizon have managed category average returns of 8.6 and 8.3 per cent in the last three years; toppers have managed 10-11 per cent. These returns have been managed in a volatile and largely rising interest rate environment.

If interest rates decline over the next two-three years due to healthy FII flows into bond markets, moderating inflation and fiscal consolidation, then these funds can earn even better returns by exploiting trading opportunities on bonds and gilts. Passive investments such as FMPs or bank deposits cannot make the most of such a scenario. Hence, open-ended debt funds may still deliver better returns than bank deposits for investors who can take some risk and hold their investments for three years.

Open-ended debt funds offer much better liquidity than bank deposits or FMPs. Breaking a fixed deposit ahead of its time entails a penalty on the interest you earn. This denies you the opportunity to exit in times of financial emergency.

Once you lock into one bank deposit, you don’t have the flexibility to switch to an alternative with a better rate, until the deposit matures. By offering anytime liquidity, open-ended debt funds give you the flexibility to shop for the best funds based on track record. If your fund under-performs its peers, you can certainly switch out to another product or fund house.

So, the one aspect in which debt mutual funds lose out to bank deposits (up to ₹1 lakh of your investment is protected by deposit insurance) is safety.

Returns earned by debt mutual funds are not predictable as they depend on movements in interest rates, corporate bond spreads and the fund manager’s ability to make the most of market moves.

Therefore, while any old bank deposit offering a high rate will probably do for your portfolio, your debt fund needs to be chosen with care.