Most retail investors prefer bank fixed deposits for the short term and medium term investments. The risk free nature of bank FDs and their assured returns are primary reasons why investors prefer FDs. However, if you look at real returns of FDs, then you will realize that parking your money in FD is not the best investment choice; by real returns, we mean post tax inflation adjusted returns. For investors in the highest tax bracket, the post tax returns from FDs rarely are able to beat inflation; in other words, the real returns from fixed deposits are negative.
Debt Mutual Funds are superior investment solutions
Debt mutual funds have historically given higher pre-tax returns compared to FDs. In the last 3 years, short and medium duration debt funds have given around 8% average annualized returns, while average FD interest rate during this period has been around 7%. For investment tenors of 3 years or more, debt mutual funds are much more tax efficient than FDs. While FD interest is taxed as per the income tax rate of the investor, long term capital gains in debt mutual funds are taxed at 20%, after allowing for indexation benefits. Indexation benefits reduce the effective tax rate on capital gains to much lower than 20%. Hence debt mutual funds are more tax friendly compared to FD for investors in the higher tax brackets. Unfortunately, while institutional investors and companies invest heavily in debt mutual funds, retail participation is still quite low. Lack of awareness about debt mutual funds is the main reason, why investors are not able to avail the benefits of debt mutual funds.
Debt mutual funds are not easy to understand
We have observed that even experienced mutual fund investors avoid debt mutual funds because these funds are considered to be too complex. In India, the bond market is not as popular among investors as the stock market. Most investors do not have an understanding of how bonds work. To complicate matters, the myriad categories of debt mutual funds add to the confusion in the minds of investors. SEBI’s mutual fund categorization directive has in fact, led to a further increase in the number of debt mutual fund categories. While SEBI’s categorization has helped bring standardization in the industry and brought much more clarity about these mutual funds for investors who have knowledge of the debt market, it is unlikely to be of much help to investors who do not have knowledge of the debt market.
We feel that, lack of knowledge of the debt market should not become roadblock to investors for availing the benefits of debt mutual funds. Debt mutual funds provide investment solutions for a large spectrum of investment needs, tenors, risk appetites and interest rate scenarios. In this two part blog post, we will try to provide some guidelines to investors for choosing debt mutual funds based on their investment needs, without going into the nitty gritties of the debt market.
Investment needs – Tenor and risk appetite
Two factors have to be kept in mind when making any investment decision – tenor and risk appetite. Tenor is the length of time, you wish to remain invested. Risk appetite is the amount of risk that you are ready to take in order to get superior returns. Tenor and risk appetite are interrelated. For short term investments, you are likely to have low risk appetite because the most important concern for you in short term investments is the safety of your capital and not high returns. For long term investments, you can have higher risk appetite, because even if the investment declines in value, there is sufficient time for the conditions to turn favorable and for you to recover the losses. At the same time, you can have low risk appetite even for long term investments, if you want regular income from your investments. You should choose debt mutual funds based on tenor and risk appetite, keeping the interrelationship between the two in mind.
Very short term investments – very low risk appetite
For very short term investments, investment tenor of 1 year or less, safety of capital and liquidityis of highest importance. Money market mutual funds like overnight funds, liquid funds and ultra-short duration funds and low duration funds are suitable for very short term investments. If you want to park you money just for few days, overnight funds will be the suitable option.
If you want to park your money for a few weeks up to 3 months, then liquid funds will be the best choice. If you want to park your money for 3 to 6 months, then you should invest in ultra-short duration funds.
For investment tenors of 6 months to a year, low duration funds will be the best option. These funds offer high degree of capital safety and high liquidity. These funds are much better options for parking cash which usually lies idle in your savings bank accounts.
Short term investments and low to moderately low risk appetite
For short term investments, investment tenor of 1 to 3 years, you want a high degree of safety and at the same time, you want stable returns. Bank FDs is the most popular investment choice for 1 – 3 year tenor. However, as discussed earlier, debt mutual funds can give better returns. Short duration funds, which invest in fixed income securities (debt and money market) which have Macaulay Durations of less than 3 years, are the best investment choice if you want low risk and stable returns. Unlike money market mutual funds like liquid funds, these funds will have some interest rate risk, but it is quite limited. Interest rate risk refers to the price sensitivity of a debt fund to interest rate changes – if interest rates fall, returns will be higher and vice versa. There can be daily or weekly volatility in Net Asset Values (NAVs)of short duration funds, but risk of making a loss over a 1 year plus tenor is extremely low. Barring exceptional bond market circumstances, these funds are likely to beat FD returns in most interest rate scenarios, as is borne out of historical data. You should ensure that your investment tenor matches more or less with the maturity profile of the fund portfolio.
Short term investments with moderately low risk appetite
If you have short term investment tenor of 1 to 3 years and want slightly higher returns, you should be prepared to take some credit risk. Credit risk refers to the risk of downgrade or in the worst case, default by the bond issuer. In both cases the price of the bond will fall and investors will see a decline in NAV / investment value. On the other hand, bonds which have credit risk pay a higher rate of interest (coupon) and investors get higher returns. If you want slightly higher returns but limited credit risk, then you should invest in Corporate Bond funds.
Corporate bond funds invest 80% of their assets under management (AUM) in highest rated corporate bonds (AAA and AA rated bonds) – these bonds are of thehighest credit quality, lowest credit risk. Corporate bonds give higher yields than Government Securities (G-Secs) which have no credit risk because they come with sovereign guarantee. Spread between the yields of highest quality corporate bonds (highest rating) and G-Secs is around 50 to 60 bps. Accordingly, corporate bond funds are expected to give higher returns than debt mutual funds of similar maturity profiles comprising primarily of G-Secs. Maturity profiles of corporate bond fund portfolios usually range from 2 to 3 years. Like in short duration funds, you should ensure that your investment tenor matches more or less with the maturity profile of the fund portfolio.
Debt mutual funds are great investment options for short to medium term investment tenors. They have the potential to give higher returns than traditional fixed income schemes like bank FDs and Government small savings schemes. Debt mutual funds offer investment solutions for a variety of investment tenors and risk appetites. In this part we discussed suitable investment options for very short to short investment tenors for very low to moderately low risk appetites. In our next part, we will discuss debt mutual funds for short to long term investment options for different risk appetites.