With debt funds giving at par returns with bank/corporate FDs, does it still make sense to invest in fixed income funds?
With interest rates coming down, the portfolio yield to maturity (YTM) of debt funds has come down drastically. While bank and corporate deposit rates have also come down, the relatively lower YTM of fixed income funds have led to confusion among investors if they should invest in Debt or simply invest with bank deposits for their fixed income allocation.
Strictly speaking, these two are not comparable. Reason, a bank or corporate deposit rate is discounted (contracted) at the beginning and it is final i.e. not contingent to any condition. In a debt MF, the portfolio YTM is the weighted average of the YTM of all securities in the portfolio. This number, or the net-of-expenses YTM, may be taken as a proxy for returns in FMPs where the instruments are held till maturity. In an open ended fund, it is dynamic – securities mature, there is continuous inflows and outflows and so on. Market varies every day and so does the portfolio YTM of open ended debt funds.
Remember, returns in debt funds is a function of accrual, which is the carry yield plus or minus the market movement i.e. the price of securities in the portfolio. For instance, if the YTM is 5.75% and expenses are 0.75%, in a flat (theoretically, not practically) market, you can expect 5% return. If market movement adds 0.5% over your holding period, you can expect 5.5% and if market is unfavourable 0.5%, you can expect 4.5%. Overall, YTM is the nearest proxy available to gauge return expectation from a debt MF.
Where do we stand today?
Currently, the one-year deposit rate of SBI bank is 4.9% and the two-year rate is 5.1%. There are banks offering a higher rate of interest but for that matter there are credit risk funds in MFs, which offer higher YTM. Let us look at relatively safer banks like SBI and assume an interest rate of 5% as bank deposit rate. For good portfolio-credit-quality debt MFs, the carry yield is less than 5%, particularly for shorter portfolio-maturity. There are longer maturity good-quality portfolios with higher carry yields.
The argument for investment in debt MFs over assured-return bank deposits comes from the investment horizon. For a horizon of at least three years, in the growth option, there is indexation benefit which makes the effective tax rate much lower. On the other hand, investors will have to pay marginal rate of taxation in bank FDs. The effective rate of returns for an FD offering 5% can come down to less than 3.5% for individual in the highest tax slabs. In debt funds, investors can easily make over 3.5% with indexation benefits.
Similarly, if the investment horizon is less than 3 years, individuals have to pay taxes at marginal rate in both FDs and fixed income funds. However, short term capital gains from debt funds can be set off against short term capital loss, which is not possible in bank FD.
In addition, RBI is keeping interest rates low to support growth in this challenging phase. In the near term, it is likely that the RBI will be supportive and keep rates on the lower side. Sometime in future, an interest rate reversal will happen as current interest rates are extremely low. As and when that happens, portfolio carry yield of debt MFs would move upward.
Conclusion
Debt funds score over bank or corporate deposits even if they offer at par returns. However, if we invest in debt funds, be mindful of portfolio credit quality and go with the shorter maturity for less volatility.
If you still want to invest bank/corporate deposits, be mindful of the issuer/institution and do not just go by attractive rates offered.
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