The RBI Monetary policy of 2012-2013 sounded the onset of rate cuts in India and with that came the certainty that interest rates will reverse in the future. What impact does this have to your overall financial planning ? The stock market is still gyrating like a loose tick tock clock in 2012; real estate hasn’t still recovered from the dumps and gold is riding high on its 2011 success and no one is sure will deliver yet again – this leaves only fixed income instruments like long term debt funds that can bring some respite to returns. Or will they ?
Long Term Debt or Bonds prices and interest rates
The reversal in interest rates is now a given, the only question is when the future cuts are going to happen.
Think for a moment – the logic says that if you know the interest rates are going to dive south, you should latch onto investments whose interest rates are currently high.
Take the example of fixed deposits – the rates are going to go down in the future so would you not take an opportunity to open a fixed deposit with the current high interest rates ?
The same goes with long term debt mutual funds.
A bit of basics first. Bond prices and interest rates share an inverse relationship – when the interest rates come down, the bond prices go up as their NAVs go up. Why does this happen?
As interest rates fall, the newer bonds issued will offer a lower interest rate (say 7%) than those that are currently trading in the market at a higher interest rate (say 8%). So the one that already exist (with 8% interest rate) see a spurt in demand and this pushes up their prices. This price is what contributes to the higher returns of such bonds and subsequently of funds that holds such bonds.
This also means that if interest rates are rising, it makes sense to buy bonds with shorter maturities to benefit from higher yields that are expected in the future. Similarly, if interest rates are going down, it makes sense to buy bonds with longer maturities.
It might make sense to read what are debt mutual funds and where they invest.
The options to park your money into long term debt fund category at this time is quite a few – Fixed Maturity Plans (FMPs), income and gilt funds and dynamic bond funds and others like fixed desposits.
Returns from debt mutual funds
The following table depicts the returns of the various debt mutual fund categories over the last 6 months and 1 year.
| Debt Fund Category | 6 months return |
1 year return |
|---|---|---|
| Debt: Short Term | 4.88 | 9.61 |
| Debt: Ultra Short Term | 4.70 | 9.39 |
| Debt: FMP | 4.64 | 9.24 |
| Debt: Liquid | 4.67 | 9.12 |
| Debt: Income | 5.32 | 9.10 |
| Debt: Gilt Medium & Long Term | 5.68 | 7.37 |
| Debt: Gilt Short Term | 4.01 | 7.01 |
Source : ValueResearchOnline.com
Long Term Debt Funds -Fixed Maturity Plans (FMPs)
FMPs are similar to fixed deposits. The difference is that unlike fixed deposits, they do not guarantee a fixed rate of return and offer better after tax returns.
The better post tax returns have to do with the fact that the FD returns are taxable depending on which tax bracket you fall into but for FMPs, indexation benefit can be applied – taxation at 10% with indexation and 20% without indexation is used.
FMPs generally have tenures from 180 days to 3 years. They are close ended and so the fund managers can plan the maturities of the holding and even give some indicative returns the FMP will offer.
Depending on your time horizon and return expectations, investors can lock in long durations FMPs at this time.
Income funds
Income funds invest in a wide variety of components – bonds/debentures, commercial papers, certificates of deposits, T-bills, government securities among others.
Depending on their objectives, income funds have the ability to vary their maturity widely.
Some of their income funds that you can consider are as follows, shown with their 1 year returns.
| Bond Name | 1 year return |
|---|---|
| Canara Robeco Income | 8.77 |
| HSBC Flexi Debt Regular | 9.82 |
| LIC Nomura MF Bond | 10.04 |
| Religare Active Income Fund Plan A | 9.82 |
| Templeton India Income | 8.37 |
| Templeton India Income Opportunities | 9.58 |
| UTI Bond | 11.59 |
Source : ValueResearchOnline.com
Note that you can also look at medium term or long term gilt funds in this category.
Dynamic bond funds
As the word itself indicates, these funds are dynamic in nature. So they are able to change the duration of the bonds inline with the interest rate cycle. So for example, when interest rates rise, they might hold a lot of cash; when interest rate decline, they can generate returns by investing fully in long term bonds.
So this is an ideal product where investors can benefit from high and low interest rates during different market economic conditions.
Dynamic bonds can invest in government bonds, corporate bonds and money market securities.
Dynamic bonds in which you can look to park your money in are below –
| Bond Name | 1 year return |
|---|---|
| SBI Dynamic Bond | 12.66 |
| IDFC Dynamic Bond A | 11.52 |
| Birla SL Dynamic Bond – Retail | 10.24 |
| Reliance Dynamic Bond | 10.89 |
Source : ValueResearchOnline.com
How to decide where to park your money?
Needless to say, your investment horizon and risk appetite are two factors that go in the decision making. If you don’t want to take much risk, go in for dynamic bond funds while if you are Ok with the market volatility, try income funds.
FMPs are ideal for conservative investors.
And if you cannot understand or stomach the headaches of these products, try the simple fixed deposits from banks or even companies.
Do align the investments to your goals – so if you want to park spare cash for 3 months, you cannot lock it in an income fund with an average maturity of 1 year.
Also, do not make the mistake of exiting your long term equity money to park in debt simply because the rates are going to be reversed. Irrespective of where the economy is going, continue investing for your long term goals in equity via SIPs.
The above argument of going with long term debt mutual funds is valid only to the debt portion of your portfolio.
To conclude, there are a variety of options you can go with while investing your money in the fixed income category – pick one that makes sense to your head, not your heart.
The different types of debt MFs available annoy me. I haven’t bothered to understand them. So for short term goals (<= 10 years)I find a recurring deposit for the debt portion simple and uncomplicated. I can open it via online banking. Interest rates in RDs are also for the same reason peaking right now and will fall soon. If I am not wrong RD taxation is the same as debt funds. I have met several goals likes this in the past 10 years.
I would slightly disagree with that.
I know you are an active investor so why not understand these ?
The difference between passive investors and active ones are that the active ones use the right products in an intelligent ways to achieve goals – sure RDs will serve the purpose but debt mutual funds can be better.
RD taxation and debt mutual fund taxation are different – Read here https://www.thewealthwisher.com/2010/08/29/taxation-of-debt-mutual-funds/
I will do an article on the latest taxation but this will give you more or less the right picture.
While FDs will give you rate of returns around 10% now, debt mutual funds can definitely go in the higher side of double digits by late 2012.
Try with a small amount of money – you can’t learn if you can’t play !
Okay got it. > 1 year Long terms debt funds will be taxed w/wo indexation while RD interest earned each year will get added to income and taxed (what I found elsewhere).
I understand your point about why one should learn about them. But is the difference in returns bet these funds and an RD that significant at least for current RD rates? Will be interesting to see.
If you are in 10% tax bracket then difference may not be significant but if you are in 30% tax bracket the difference in post tax returns will favour debt instruments with at least 1-2% I am guessing.
That is my guess too. If my goals are met should I loose sleep over 1-2% difference in interest? For any goal less than 5 years away I would confidently say yes. Longer than that maybe one should worry especially if equity is underperforming wrt your calculations.
Personally the only risk associated with a debt instrument which I can stomach is inflation risk. Which is why I dont like debt funds. I dont like fluctuating debt instrument returns. I just dont have the appetite for it.
Pattu, there are many risks associated with a debt fund – another article will cover those.
I still don’t understand why you don;t like debt funds, maybe I am not getting you correctly.
A 1-2% of interest rate of return can be a huge difference if the amount is huge and the term is short. But while returns are one factor, what is important is to understand that there are instruments out there that can give you better returns depending on where the market is going. Using it intelligently should be the aim.
I think you can do it Paatu 🙂 !
@Pattu, when you say inflation risk, you mean to say debt instruments won’t be able to beat inflation in the long run?
Hi,
It was excellent to read your article on all options related to investing into debt funds. Your are 100% accurate that this is the time (probably even better if some one would have invested in Jan 2012, but it is still not late) to invest into debt funds. However, after 1 year, it may be a time to start switching out of debt into Equity Funds. The best option is to invest lumpsum into Debt fund as of now, with a STP into Equity plan. As the interest rates would decrease, the bond prices would move up with the Equities also (probably) shooting up due to reduced interest costs for the companies.
Regards
BanyanFA
Yes, that is the best way to do it actually.
I also agree that one could have invested in the last 3 months, if not, this is probably the last chance.
Yes, I thought the same and started investing from Jan :). This was first in my 2012 to-do list. I was planning for lumpsum (into IDFC dynamic Bond) and do STP though couldn’t do it due to some reasons :(. Let’s see.
Where did you invest Chirag, if I may ask?
You might want to refer to the detailed article on tax implications of Mutual funds by checking out http://insight.banyanfa.com/?p=690.
Regards
BanyanFA
Really enjoyed reading this article especially the way it ended.
“The above argument of going with long term debt mutual funds is valid only to the debt portion of your portfolio.”
People tend to shift money from equity to debt in the financial condition we are in today. But this should be the case only when you are nearing your goal to save money from equity volatility not otherwise.
In my opinion FMPs and dynamic bond funds are the best of the lot.
FMPs simply because of their taxation benefits.
Dynamic bond funds because they will take care of interest rates fluctations. Investors don’t have to worry about moving money between debt instruments every time interest rates are revised.
Yes Vivek, I think you arr right. These are potentially the best options.
Glad you liked the article.
Very good analysis. HDFC Prudence & MIP’s meet my debt requirements. I never understood how FMP’s work and always stayed away from it.
@Rakesh – I believe HDFC Prudence has higher exposure to equity, can we call it a debt fund in that case or it should be called a balanced fund?
@Radhey – I didn’t understand why dynamic bond has lower risk than income fund. Shouldn’t it be other way by investing long term income fund has lower exposure to volatility.
“If you don’t want to take much risk, go in for dynamic bond funds while if you are Ok with the market volatility, try income funds.”
You are right Dip about HDFC Prudence. With around 60% exposure to equity it does fall under balanced category fund.
HDFC Prudence is not a debt fund, it is a balanced fund.
Yes Prudence is a balanced fund, I should have clarified Prudence as debt fund in my MF portfolio. My MF portfolio consists of Large, small, mid-cap and debt fund. As for debt funds in my regular portfolio FD & RD serves my purpose. For goals between 1-2 years FD & RD works perfect for me.
There is another option to buck the Debt portfolio – Monthly Income Plans provided by Mutual funds. It would ideally be the best option !
Regards
BanyanFA
@BFA,
Agree with you on MIP’s, i have been investing since last few years and have earned interest in the range of 10-12%.
Yeah, with a 25% max allocation to equities, they also serve a good purpose.
Honestly speaking, investors are spoiled for choice as far as debt goes – so many options !
Equity is rather straight forward, in debt, investors might get confused !
Which MIPs are your favorite buys ?
I like Birla Sunlife MIP & Reliance MIP and have invested in both of these schemes.
After comparing the returns between MIP & Dynamic bond funds, thinking to shift a part of my investment and will monitor.
Sorry shifting your money from where to where ?
Shifting from MIP’s to Dynamic bonds