How Debt Funds Fit Into Your Portfolio

Interest rates have started to move southwards with Reserve Bank of India (RBI) easing the monetary policy since start of this calendar year. RBI has cut key policy rates thrice since January 2013. There is an expectation that rates would fall further going forward. This augurs well for debt funds, as their performance is linked with interest rates moving in an economy.

When interest rates fall, bond prices go up (they share an inverse relationship), thereby creating capital gain opportunities for debt funds.

Let’s understand with an example:

There is a bond ‘X’ issued at a price of ` 100 with an interest rate of 10 per cent. When interest rates fall in an economy, the new bonds come at lower interest rates. Say, a new bond ‘Y’ comes at an interest rate of 8 per cent. With this, the demand for bond paying higher interest rate, i.e. bond ‘X’ paying 10 per cent, will go up and in turn, its price, e.g. from ` 100 to ` 110. This results in capital gains of ` 10.

The last financial year (FY13)

has had many capital gain opportunities for debt funds due to fall in 10-year benchmark government security (G-Sec) yield, from high of 8.50 per cent to 7.75 per cent. This resulted in attractive returns for various categories of debt funds (see chart below).

FY13 (April 2012 – March 2013); Category returns are average of all funds in the respective category; Source: Crisil Fund Analyzer

"Not only at the longer-end of the curve, but ample opportunities were available across the yield curve, as interest rates lowered on back of slower credit pick up and liquidity management measures taken by RBI during FY13," says

Sachin Jain, Research Analyst – Mutual Funds, ICICIdirect.

Now the question is:

Whether such opportunities still exist or is it too late?

With interest rates expected to fall further, over the next one or two years, debt funds still present a lucrative investment opportunity, believes

Jain. "We expect system rates, as a whole, to be lower over the next one or two years. Inflation, which was the biggest hurdle last year, has softened in the last 2-3 months. Growth has deteriorated and credit pick-up has been at an all-time low. RBI has also assured it will take measures needed to support liquidity. All these factors should pull down interest rates lower especially at the shorter end. We expect additional 50 basis points (bps) repo rate cut to be announced in FY14," he adds.

"However, risk arises if there is a sharp spike in global commodity prices, rupee appreciation, or disruption in monsoons, which may

halt the downward inflation trajectory. Political risk also remains, next year being the election year," cautions Jain.Keeping these things in mind, what are the best debt fund options available now?

In general, in a rising interest rate scenario, short-term funds do well, as they are less impacted by the rising interest rates. On the other hand, in case of a declining interest rate scenario, long-term funds perform well as they are better placed to capture capital gain opportunities due to their longer duration (longer the duration, higher the capital gains).

"In the current scenario, as we enter into a declining interest rate scenario, investment opportunities are available across the yield curve," says Jain.

"Long term income funds or dynamic bond funds have the potential to outperform as they will be gaining more from softening interest rates as compared to shorter duration funds. Short-term debt funds, however, remain evergreen funds for all types of investors," he adds.

What should you choose?

Basically, your investment in debt funds should primarily depend on time horizon of your goal. There are debt funds available across various durations – 1 month, 3 months, 6 months, 1 year, etc. You then need to select the funds with duration that matches with the time-frame of your goal.

We have examined the average maturity/duration of several debt fund categories to help you find the funds best suited to your needs:

Debt funds: What are the tax implications?

Short-term capital gains (< 1 year):

Any short-term capital gains that arise due to selling of a debt fund before 1 year, are added to your income, and taxed according to your tax slab.

Long-term capital gains (> 1 year):

Here, the taxation depends on whether you would like to use the indexation or not. Indexation is a benefit that Indian tax laws provide you to inflate your cost price to account for inflation. Without indexation, the capital gains arising from selling a debt fund are taxed at 10 per cent, and with indexation, these are taxed at 20%.

The tax can be calculated using both the methods, with or without indexation, and the lower of the two can be paid.

Dividends: Dividends received from debt funds are tax-free in your hands. But there is dividend distribution tax (DDT) to be paid by mutual funds to income tax department.After adjusting for income tax, returns from debt funds fare better than those from bank FDs (see the illustration below).

The above illustration clearly shows that despite Bank FD rates being higher than the returns from debt funds, post-tax gains are higher in case of debt funds.

Investors in 20 per cent and 30 per cent tax brackets gain more

from tax-efficient debt funds than those in the 10 per cent tax slab, which is evident from the above indexation table.

Summing up

As a part of your asset allocation strategy, it is important that you allocate some portion of your capital in debt instruments, to provide stability. Debt funds can be used to do so, given its benefits of liquidity and better post-tax returns.